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Costco Wholesale 10-K 2007
Annual Report
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-K

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended September 2, 2007

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 0-20355

 


Costco Wholesale Corporation

(Exact name of registrant as specified in its charter)

 

Washington   91-1223280
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer Identification No.)

999 Lake Drive, Issaquah, WA 98027

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: (425) 313-8100

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on

which registered

Common Stock, $.005 Par Value   The NASDAQ Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act: None

 


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES x    NO ¨

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES ¨    NO x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x    NO ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer x              Accelerated Filer ¨             Non-accelerated filer ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). YES ¨    NO x

The aggregate market value of the voting stock held by non-affiliates of the registrant at February 16, 2007 was $25,659,670,154

The number of shares outstanding of the registrant’s common stock as of October 5, 2007 was 434,083,536

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Company’s Proxy Statement for the Annual Meeting of Stockholders to be held on January 29, 2008 are incorporated by reference into Part III of this Form 10-K.

 



Table of Contents

COSTCO WHOLESALE CORPORATION

ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED SEPTEMBER 2, 2007

 

          Page

PART I

     

Item 1.

   Business    3

Item 1A.

   Risk Factors    7

Item 1B.

   Unresolved Staff Comments    12

Item 2.

   Properties    13

Item 3.

   Legal Proceedings    13

Item 4.

   Submission of Matters to a Vote of Security Holders    13

PART II

     

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   14

Item 6.

   Selected Financial Data    15

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   16

Item 7A.

   Quantitative and Qualitative Disclosures About Market Risk    32

Item 8.

   Financial Statements and Supplementary Data    33

Item 9.

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   33

Item 9A.

   Controls and Procedures    33

Item 9B.

   Other Information    34

PART III

     

Item 10.

   Directors, Executive Officers and Corporate Governance    35

Item 11.

   Executive Compensation    36

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   36

Item 13.

   Certain Relationships and Related Transactions, and Director Independence    36

Item 14.

   Principal Accounting Fees and Services    36

PART IV

     

Item 15.

   Exhibits, Financial Statement Schedules    36

 

2


Table of Contents

PART I

Item 1—Business

Costco Wholesale Corporation (“Costco” or the “Company”) began operations in 1983 in Seattle, Washington. In October 1993, we merged with The Price Company, which had pioneered the membership warehouse concept, to form Price/Costco, Inc., a Delaware corporation. In January 1997, after the spin-off of most of our non-warehouse assets to Price Enterprises, Inc., we changed our name to Costco Companies, Inc. On August 30, 1999, we reincorporated from Delaware to Washington and changed our name to Costco Wholesale Corporation. Our common stock trades on the NASDAQ under the symbol “COST.”

General

We operate membership warehouses based on the concept that offering our members very low prices on a limited selection of nationally branded and selected private-label products in a wide range of merchandise categories will produce high sales volumes and rapid inventory turnover. This 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, enables us to operate profitably at significantly lower gross margins than traditional wholesalers, mass merchandisers, supermarkets and supercenters.

We buy the majority of our merchandise directly from manufacturers and route it to a cross-docking consolidation point (“depot”) or directly to our warehouses. Our depots receive container-based shipments from manufacturers and reallocate these goods for shipment to our individual warehouses, generally in less than twenty-four hours. This maximizes freight volume and handling efficiencies, thereby lowering our receiving costs by eliminating many of the costs associated with multiple step distribution channels, which include purchasing from distributors as opposed to manufacturers, use of central receiving, storing and distributing warehouses, and storage of merchandise in locations off the sales floor.

Because of our high sales volume and rapid inventory turnover, we generally have the opportunity to sell and be paid for inventory before we are required to pay many of our merchandise vendors, even though we take advantage of early payment discounts whenever available to us. As sales increase and inventory turnover becomes more rapid, a greater percentage of inventory is financed through payment terms provided by vendors rather than by our working capital.

Our typical warehouse format averages approximately 140,000 square feet; newer units tend to be larger. Floor plans are designed for economy and efficiency in the use of selling space, the handling of merchandise and the control of inventory. Because shoppers are attracted principally by the quality of merchandise and the availability of low prices, our warehouses need not have elaborate facilities. By strictly controlling the entrances and exits of our warehouses and using a membership format, we have limited inventory losses to less than two-tenths of one percent of net sales in each of the last three fiscal years—well below those of typical discount retail operations.

We generally limit marketing and promotional activities to new warehouse openings, occasional direct mail marketing to prospective new members and regular direct marketing programs (such as The Costco Connection, a magazine we publish for our members, and coupon mailers) to existing members promoting selected merchandise. These practices result in lower marketing expenses as compared to typical retailers. In connection with new warehouse openings, our marketing teams personally contact businesses in the area that are potential wholesale members. These contacts are supported by direct mailings during the period immediately prior to opening. Potential Gold Star (individual) members

 

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Item 1—Business (Continued)

 

are contacted by direct mail or by providing membership offerings to be distributed through employee associations and other entities. After a membership base is established in an area, most new memberships result from word-of-mouth advertising, follow-up messages distributed through regular payroll or other organizational communications to employee groups and ongoing direct solicitations to prospective Business and Gold Star members.

Our warehouses generally operate on a seven-day, 69-hour week. Generally, warehouses are open weekdays between 10:00 a.m. and 8:30 p.m., with earlier closing hours on the weekend. Gasoline operations generally have extended hours. Because the hours of operation are shorter than those of traditional retailers, discount retailers and supermarkets and due to other efficiencies inherent in a warehouse-type operation, labor costs are lower relative to the volume of sales. Merchandise is generally stored on racks above the sales floor and displayed on pallets containing large quantities of each item, thereby reducing labor required for handling and stocking.

Our merchandising strategy is to provide our members with a broad range of high quality merchandise at prices consistently lower than could be obtained elsewhere. An important element of this strategy is to carry only those products on which we can provide our members significant savings. We seek to limit specific items in each product line to fast-selling models, sizes and colors. Therefore, we carry an average of approximately 4,000 active stockkeeping units (SKUs) per warehouse in our core warehouse business, as opposed to discount retailers and supermarkets that normally stock 40,000 SKUs or more. Many consumable products are offered for sale in case, carton or multiple-pack quantities only.

In keeping with our policy of member satisfaction, we generally accept returns of merchandise. In fiscal 2007, we introduced a 90-day return policy in the United States on certain electronic items. Additionally, we now provide, free of charge, technical support service, as well as an extended warranty on certain electronic items.

The following table indicates the approximate percentage of net sales accounted for by major category of items:

 

     2007     2006     2005  

Sundries (including candy, snack foods, tobacco, alcoholic and nonalcoholic beverages and cleaning and institutional supplies)

   23 %   24 %   25 %

Hardlines (including major appliances, electronics, health and beauty aids, hardware, office supplies, garden and patio, sporting goods, furniture, and automotive supplies)

   21 %   20 %   20 %

Food (including dry and institutionally packaged foods)

   19 %   19 %   19 %

Softlines (including apparel, domestics, jewelry, housewares, media, home furnishings, cameras and small appliances)

   11 %   12 %   12 %

Fresh Food (including meat, bakery, deli and produce)

   12 %   11 %   11 %

Ancillary and Other (including gas stations, pharmacy, food court, optical, one-hour photo, hearing aid and travel)

   14 %   14 %   13 %

 

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Item 1—Business (Continued)

 

Ancillary businesses within or next to our warehouses provide expanded products and services and encourage members to shop more frequently. The following table indicates the number of ancillary businesses in operation at fiscal year end:

 

     2007    2006    2005

Food Court and Hot Dog Stands

   482    452    427

One-Hour Photo Centers

   480    450    423

Optical Dispensing Centers

   472    442    414

Pharmacies

   429    401    374

Gas Stations

   279    250    225

Hearing-Aid Centers

   237    196    168

Print Shops and Copy Centers

   8    9    10

Number of warehouses

   488    458    433

Warehouses operated by our Mexico joint venture are not included above. At September 2, 2007, our 50% owned joint venture in Mexico operated 30 warehouses.

Our electronic commerce businesses, costco.com in the U.S. and costco.ca in Canada, provide our members additional products generally not found in our warehouses, in addition to services such as digital photo processing, pharmacy, travel and membership services.

Our warehouses accept cash, checks, certain debit cards, American Express and a private label Costco credit card. Losses associated with dishonored checks have been minimal as members who have issued dishonored checks are identified and prevented from cashing checks at the point of sale until restitution is made.

We have direct buying relationships with many producers of national brand name merchandise. No significant portion of merchandise is obtained from any one of these or any other single supplier. We have not experienced any difficulty in obtaining sufficient quantities of merchandise, and believe that if one or more of our current sources of supply became unavailable, we would be able to obtain alternative sources without experiencing a substantial disruption of our business. We also purchase selected private label merchandise, as long as quality and customer demand are comparable and the value to our members is greater.

Financial information of our segments and geographic areas is included in Note 12, Segment Reporting, to the accompanying consolidated financial statements.

We report on a 52/53-week fiscal year, consisting of thirteen four-week periods and ending on the Sunday nearest the end of August. The first, second and third quarters consist of three periods each, and the fourth quarter consists of four periods (five weeks in the thirteenth period in a 53-week year). There is no material seasonal impact on our operations, except an increased level of net sales and earnings during the winter holiday season. Fiscal years 2007 and 2005 each consisted of 52 weeks, and fiscal year 2006 was a 53-week year.

Membership Policy

Our membership format is designed to reinforce customer loyalty and provide a continuing source of membership fee revenue, which allows us to offer low prices.

Members can utilize their memberships at any Costco warehouse location in any country. We have two primary types of members: Business, and Gold Star (individual). In addition, U.S. and Canadian

 

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Item 1—Business (Continued)

 

members can upgrade to an Executive Membership. We continue to experience strong member renewal rates, currently at 87%. Businesses, including individuals with a business license, retail sales license or other evidence of business existence, may become Business members. Business members generally pay an annual membership fee of $50 for the primary and spouse membership card, with add-on membership cards available for an annual fee of $40 (including a free spouse card). A significant number of our business members also shop at Costco for their personal needs.

Individual memberships (Gold Star memberships) are available to individuals who do not qualify for a Business membership. Individual members generally pay an annual membership fee of $50, which includes a spouse card.

Our membership base was made up of the following (in thousands):

 

     September 2,
2007
   September 3,
2006

Gold Star

   18,600    17,300

Business

   5,400    5,200
         

Total primary cardholders

   24,000    22,500

Add-on cardholders

   26,400    25,200
         

Total cardholders

   50,400    47,700
         

The rates for Business and Gold Star members discussed above reflect the $5 increase that went into effect on May 1, 2006 for new members and July 1, 2006 for existing members.

Executive Membership is available to all members in the U.S. and Canada for an annual fee of $100. The Executive Membership program offers members additional savings and benefits on various business and consumer services offered by Costco, such as merchant credit card processing, small business loans, auto and home insurance, business telephone service, check printing, and real estate and mortgage services. The services offered are generally provided by third-party providers and vary by state. In addition, Executive members qualify for a 2% reward (which can be redeemed at Costco warehouses), up to a maximum of $500 per year, on all qualified purchases made at Costco. At the end of fiscal 2007 and 2006, Executive members represented 23% and 20%, respectively, of our primary membership base and the percentage of our net sales attributable to these members continues to increase.

Labor

Our employee count approximated:

 

     September 2,
2007
   September 3,
2006

Full-time employees

   70,000    66,000

Part-time employees

   57,000    53,000
         

Total employees

   127,000    119,000
         

These numbers exclude approximately 9,000 and 8,000 individuals who were employed by Costco Mexico (a 50%-owned joint venture) as of September 2, 2007 and September 3, 2006, respectively, which is not consolidated in our financial statements, but is accounted for using the equity method. Approximately 13,900 hourly employees in certain of our locations in California, Maryland, New Jersey, New York and one warehouse in Virginia are represented by the International Brotherhood of Teamsters. All remaining employees are non-union. We consider our employee relations to be very good.

 

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Item 1—Business (Continued)

 

Competition

Our industry is highly competitive, based on factors such as price, merchandise quality and selection, warehouse location and member service. Over 1,200 warehouse club locations exist across the U.S. and Canada, including our 454 North American warehouses, and every major metropolitan area has one, if not several, club operations. In addition to other membership warehouse operators such as Wal-Mart’s Sam’s Club and BJ’s Wholesale Club, we compete with a wide range of national and regional retailers and wholesalers, including supermarkets, supercenters, general merchandise chains, specialty chains, gasoline stations, as well as electronic commerce businesses. Wal-Mart, Target and Kohl’s are significant general merchandise retail competitors. We also compete with low-cost operators selling a single category or narrow range of merchandise, such as Lowe’s, Home Depot, Office Depot, PetSmart, Staples, Trader Joe’s, Whole Foods, Best Buy and Barnes & Noble.

Regulation

Certain state laws require that we apply minimum markups to our selling prices for specific goods, such as tobacco products, alcoholic beverages and gasoline. While compliance with such laws may cause us to charge somewhat higher prices than we otherwise would charge, other retailers are also typically governed by the same restrictions, and we believe that compliance with such laws does not have a material adverse effect on our operations.

It is our policy to sell at lower than manufacturers’ suggested retail prices. Some manufacturers attempt to maintain the resale price of their products by refusing to sell to us or to other purchasers that do not adhere to suggested retail prices or that otherwise sell at discounted prices. To date, we believe that we have not been materially affected by our inability to purchase directly from such manufacturers. Both federal and state legislation is proposed from time to time which, if enacted, would restrict our ability to purchase goods or extend the application of laws enabling the establishment of minimum prices. We cannot predict the effect on our business of the enactment of such federal or state legislation.

Certain states, counties and municipalities have enacted or proposed laws and regulations that would prevent or restrict the operations or expansion plans of certain large retailers and warehouse clubs, including us, within their jurisdictions. We believe that, if enacted, such laws and regulations could have a material adverse affect on our operations.

Available Information

We maintain an internet website at www.costco.com. We make available through the Investor Relations section of our website, free of charge, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, Proxy Statements and Forms 3, 4 and 5, and any amendments to those reports, as soon as reasonably practicable after filing such material with, or furnishing such documents to, the Securities and Exchange Commission (SEC). The information found on our website is not part of this or any other report filed with or furnished to the SEC.

Item 1A—Risk Factors

Certain statements contained in this document constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. They include statements that address activities, events, conditions or developments that we expect or anticipate may occur in the future. 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.

 

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Item 1A—Risk Factors (Continued)

 

The risks described below could materially and adversely affect our business, financial condition or results of operations. They could cause our actual results to differ materially from our historical experience and from results predicted by our forward-looking statements. Those statements may relate to such matters as sales growth, increases in comparable store sales, impact of cannibalization, price changes, earnings performance, earnings per share, stock-based compensation expense, warehouse openings and closures, the effect of adopting certain accounting standards, future financial reporting, financing, margins, return on invested capital, strategic direction and the demand for our products and services. You should read these risk factors in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 of this Report and our consolidated financial statements and related notes in Item 8 of this Report. There also may be other factors that we cannot anticipate or that are not described in this report, generally because we do not perceive them to be material, that could cause results to differ materially from our expectations. Forward-looking statements speak only as of the date they are made, and we do not undertake to update these forward-looking statements. You are advised, however, to review any further disclosures we make on related subjects in our periodic filings with the SEC.

We face strong competition from other retailers and wholesale club operators, which could negatively affect our financial performance.

The retail business is highly competitive. We compete for members, employees, warehouse sites, products and services and in other important respects with many other local, regional and national retailers, both in the United States and in foreign countries. We compete with other wholesale club operators, discount retailers, retail and wholesale grocers and general merchandise wholesalers and distributors, as well as electronic commerce retailers, wholesalers and catalog businesses. Internationally, we compete with retailers who operate department, drug, variety and specialty stores, supermarkets, supercenter stores, wholesale clubs, internet-based retailers and catalog businesses. Such retailers and wholesale club operators compete in a variety of ways, including merchandise selection and availability, services offered to members, location, store hours and price. Our ability to respond effectively to competitive pressures and changes in the retail markets could negatively affect our financial performance. Some competitors may have greater financial resources, better access to merchandise, and greater market penetration than we do.

General economic factors, domestically and internationally, may adversely affect our financial performance.

Higher interest rates, energy costs, inflation, levels of unemployment, healthcare costs, fluctuations of certain commodity prices, consumer debt levels, and other economic factors could adversely affect demand for our products and services or require a change in the mix of products we sell. These factors can also increase our cost of sales and/or operating, selling, general and administrative expenses, and otherwise adversely affect our operations and results. General economic conditions can also be affected by the outbreak of war, acts of terrorism or other significant national or international events.

Our growth strategy includes expanding our business, both in existing markets and by opening warehouses in new markets.

Our future growth is dependent, in part, on our ability to build or lease new warehouses. We compete with other retailers and businesses for suitable locations. Local land use and other regulations restricting the construction of our warehouses, as well as local community actions opposed to the location of our warehouses at specific sites and the adoption of certain local laws restricting our operations and environmental regulations may impact our ability to find suitable locations, and increase the cost of constructing, leasing and operating our warehouses. We also may have difficulty negotiating leases or

 

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Item 1A—Risk Factors (Continued)

 

real estate purchase agreements on acceptable terms. Failure to manage these and other similar factors effectively will affect our ability to build or lease new warehouses, which may have a material adverse affect on our future profitability.

We seek to expand our business in existing markets in order to attain a greater overall market share. Because our warehouses typically draw members from their local areas, a new warehouse may draw members away from our nearby existing warehouses and may cause comparable warehouse sales performance and member traffic at those existing warehouses to slow or decline.

We also intend to open warehouses in new markets. The risks associated with entering a new market include difficulties in attracting members due to a lack of familiarity with us, our lack of familiarity with local member preferences and seasonal differences in the market. In addition, entry into new markets may bring us into competition with new competitors or with existing competitors with a large, established market presence. While we have a track record of profitable growth, in new markets we cannot ensure that our new warehouses will be profitably deployed; as a result, our future profitability may be delayed or otherwise materially adversely affected.

Any inability to open new warehouses on schedule could hurt our financial performance.

We expect to increase our presence in existing markets and enter new markets. Our opening of new warehouses, domestically and internationally, will depend on our ability to: identify and secure suitable locations; negotiate leases or real estate purchase agreements on acceptable terms; attract and train qualified employees; and manage preopening expenses, including construction costs. We compete with other retailers and businesses for suitable locations for our warehouses. Our ability to open new warehouses also is affected by environmental regulations, local zoning issues and other laws related to land use. Failure to effectively manage these and other similar factors will affect our ability to open warehouses on schedule, which could adversely affect our financial performance.

We are highly dependent on the financial performance of our United States and Canada operations.

Our financial performance is highly dependent on our United States and Canada operations, which comprised 94% of consolidated net sales in both fiscal 2007 and 2006, and 93% and 94% of operating income in fiscal 2007 and 2006, respectively. Furthermore, we are highly dependent on our California operations, which comprised 28% and 31% of consolidated net sales in fiscal 2007 and 2006, respectively. Any substantial slowing or sustained decline in these operations could materially adversely affect our business and financial results. Declines in financial performance of our United States and Canada operations could arise from, among other things: failing to meet targets for warehouse openings; declines in actual or estimated comparable warehouse sales growth rates and expectations; negative trends in operating expenses, including increased labor and healthcare costs; cannibalizing existing locations with new warehouses; shifts in sales mix toward lower gross margin products; changes or uncertainties in economic conditions in our markets; and failing consistently to provide high quality products and innovative new products to retain our existing member base and attract new members.

We depend on vendors to supply us with quality merchandise at the right time and at the right price.

We depend heavily on our ability to purchase merchandise in sufficient quantities at competitive prices. We have no assurances of continued supply, pricing or access to new products, and any vendor could at any time change the terms upon which it sells to us or discontinue selling to us. Sales demands may lead to insufficient in-stock positions of our merchandise.

 

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Item 1A—Risk Factors (Continued)

 

We purchase our merchandise from numerous domestic and foreign manufacturers and importers. We have thousands of vendor relationships. Our inability to acquire suitable merchandise on acceptable terms or the loss of key vendors could negatively affect us. We may not be able to develop relationships with new vendors, and products from alternative sources, if any, may be of a lesser quality and/or more expensive than those from existing vendors.

Our vendors are subject to risks, including labor disputes, union organizing activities, financial liquidity, inclement weather, natural disasters, supply constraints, and general economic and political conditions, that could limit their ability to timely provide us with acceptable merchandise. For these or other reasons, one or more of our vendors might not adhere to our quality control or legal or regulatory standards. These deficiencies may delay or preclude delivery of merchandise to us and might not be identified before we sell to our members. This failure could lead to litigation and recalls, which could damage our reputation and our private label brand, increase our costs, and otherwise hurt our business.

In addition, the United States’ foreign trade policies, tariffs and other impositions on imported goods, trade sanctions imposed on certain countries, the limitation on the importation of certain types of goods or of goods containing certain materials from other countries and other factors relating to foreign trade are beyond our control.

We may not timely identify or effectively respond to consumer trends, which could negatively affect our relationship with our members, the demand for our products and services, and our market share.

It is difficult to consistently and successfully predict the products and services our members will demand. The success of our business depends in part on our ability to identify and respond to evolving trends in demographics and consumer preferences. Failure to timely identify or effectively respond to changing consumer tastes, preferences and spending patterns could negatively affect our relationship with our members, the demand for our products and services and our market share.

Changes in accounting standards and subjective assumptions, estimates and judgments by management related to complex accounting matters could significantly affect our financial results.

Generally accepted accounting principles and related accounting pronouncements, implementation guidelines and interpretations with regard to a wide range of matters that are relevant to our business, such as revenue recognition, sales returns reserve, impairment of long-lived assets and warehouse closing costs, inventories, self insurance, stock-based compensation, income taxes, unclaimed property laws and litigation, are highly complex and involve many subjective assumptions, estimates and judgments by our management. Changes in these rules or their interpretation or changes in underlying assumptions, estimates or judgments by our management could significantly change our reported or expected financial performance.

Our international operations subject us to risks associated with the legislative, judicial, accounting, regulatory, political and economic factors specific to the countries or regions in which we operate, which could adversely affect our financial performance.

Our international operations could form a larger portion of our business in future years. Future operating results internationally could be negatively affected by a variety of factors, many beyond our control. These factors include political conditions, economic conditions, regulatory constraints, currency regulations and exchange rates, and other matters in any of the countries or regions in which we operate,

 

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Item 1A—Risk Factors (Continued)

 

now or in the future. Other factors that may impact international operations include foreign trade, monetary and fiscal policies both of the United States and of other countries, laws and regulations of foreign governments, agencies and similar organizations, and risks associated with having major facilities located in countries which have been historically less stable than the United States.

Implementation of technology initiatives could disrupt our operations in the near term and fail to provide the anticipated benefits.

We have made and will continue to make significant technology investments both in our operations and in our administrative functions. The costs, potential problems and interruptions associated with the implementation of technology initiatives could disrupt or reduce the efficiency of our operations in the near term. In addition, new or upgraded technology might not provide the anticipated benefits; it might take longer than expected to realize the anticipated benefits or the technology might fail.

Market expectations for our financial performance is high.

We believe that the price of our stock reflects high market expectations for our future operating results. Any failure to meet these expectations for our comparable warehouse sales growth rates, earnings and earnings per share or new warehouse openings could cause the market price of our stock to drop.

Cost related to natural disasters could unfavorably affect our financial performance.

The occurrence of one or more natural disasters, such as hurricanes or earthquakes (particularly in California) could unfavorably affect our operations and financial performance. Such events could result in physical damage to one or more of our properties, the temporary closure of one or more warehouses or depots, the temporary lack of an adequate work force in a market, the temporary or long-term disruption in the supply of products from some local and overseas suppliers, the temporary disruption in the transport of goods from overseas, delays in the delivery of goods to our depots or warehouses within a country in which we operate and the temporary reduction in the availability of products in our warehouses.

We are subject to a wide variety of federal, state, regional, local and international laws and regulations relating to the use, storage, discharge, and disposal of hazardous materials and hazardous and non-hazardous wastes, and other environmental matters.

Any failure to comply with these laws could result in costs to satisfy environmental compliance, remediation requirements, or the imposition of severe penalties or restrictions on operations by governmental agencies or courts that could adversely affect our operations.

We are involved in a number of legal proceedings, and while we cannot predict the outcomes of such proceedings and other contingencies with certainty, some of these outcomes may unfavorably affect our operations or increase our costs.

We are involved in a number of legal proceedings, including grand jury investigations, consumer, employment, tort and other litigation. We cannot predict with certainty the outcomes of these legal proceedings and other contingencies, including environmental remediation and other proceedings commenced by governmental authorities. The outcome of some of these legal proceedings and other contingencies could require us to take or refrain from taking actions which could unfavorably affect our operations or could require us to pay substantial amounts of money. Additionally, defending against these lawsuits and proceedings may involve significant expense and diversion of management’s attention and resources. Our business requires compliance with a great variety of laws and regulations. Failure to achieve compliance could subject us to lawsuits and other proceedings, and lead to damage awards, fines and penalties.

 

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Item 1A—Risk Factors (Continued)

 

Failure of our internal control over financial reporting could harm our business and financial results.

Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting for external purposes in accordance with U.S. generally accepted accounting principles. Internal control over financial reporting includes: maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of the financial statements; providing reasonable assurance that our receipts and expenditures of our assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of our financial statements would be prevented or detected. Any failure to maintain an effective system of internal control over financial reporting could limit our ability to report our financial results accurately and timely or to detect and prevent fraud.

Our success depends upon our ability to attract, train and retain highly qualified employees.

To be successful, we must attract, train and retain a large and growing number of highly qualified associates, while controlling related labor costs. Our ability to control labor costs is subject to numerous external factors, including prevailing wage rates and healthcare and other insurance costs. We compete with other retail and non-retail businesses for these employees and invest significant resources in training and motivating them. We also depend on our executives and other key employees for our success. There is no assurance that we will be able to attract or retain highly qualified employees in the future.

If we do not maintain the security of member-related information, we could damage our reputation with members, incur substantial additional costs and become subject to litigation.

As do most retailers and wholesale club operators, we receive certain personal information about our members. In addition, our online operations at www.costco.com and www.costco.ca depend upon the secure transmission of confidential information over public networks, including information permitting cashless payments. A compromise of our security systems or those of some of our suppliers, or other business partners that results in our member’s personal information being obtained by unauthorized persons could adversely affect our reputation with our members and others, as well as our operations, results of operations, financial condition and liquidity, and could result in litigation against us or the imposition of penalties. In addition, a security breach could require that we expend significant additional resources related to the security of information systems and could result in a disruption of our operations, particularly our online sales operations.

Privacy and Information Security

The use of individually identifiable data by our business and our business associates is regulated at the international, federal and state levels. Privacy and information security laws and regulations change, and compliance with them may result in cost increases due to necessary systems changes and the development of new administrative processes. If we or our business associates fail to comply with these laws and regulations or experience a data security breach, our reputation could be damaged, possibly resulting in lost future business, and we could be subjected to additional legal risk as a result of non-compliance.

Item 1B—Unresolved Staff Comments

None.

 

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Item 2—Properties

Warehouse Properties

At September 2, 2007, Costco operated 488 membership warehouses:

NUMBER OF WAREHOUSES

 

     Own Land
and Building
   Lease Land
and/or
Building(1)
   Total

United States

   301    82    383

Canada

   62    9    71

United Kingdom

   18    1    19

Japan

   1    5    6

Korea

   2    3    5

Taiwan

   0    4    4
              

Total

   384    104    488
              

(1) 61 of the 104 leases are land-leases only, where Costco owns the building.

The following schedule shows warehouse openings (net of closings) by region for the past five fiscal years and expected warehouse openings (net of closings) through December 31, 2007:

 

Openings by Fiscal Year

   United States    Canada    Other
International
   Total   

Total Warehouses

in Operation

2003 and prior

   309    61    27    397    397

2004

   18    2    0    20    417

2005

   11    2    3    16    433

2006

   20    3    2    25    458

2007

   25    3    2    30    488

2008 (expected through 12/31/07)

   6    4    1    11    499
                      

Total

   389    75    35    499   
                      

Warehouses operated by our Mexico joint venture are not included in the above schedules. At September 2, 2007, our 50% owned joint venture in Mexico operated 30 warehouses.

At the end of fiscal 2007, our warehouses contained approximately 68.6 million square feet of operating floor space: 54.4 million in the United States, 9.6 million in Canada and 4.6 million in other international locations, excluding Mexico.

Our executive offices are located in Issaquah, Washington and occupy approximately 395,000 square feet. We operated eight regional offices in the United States, two regional offices in Canada and four regional offices internationally at the end of fiscal 2007, containing approximately 309,000 square feet. Additionally, we operate regional cross-docking facilities (depots) for the consolidation and distribution of most shipments to the warehouses, and various processing, packaging, and other facilities to support ancillary and other businesses. At the end of fiscal 2007, we operated eleven depots in the United States, three in Canada and two internationally, excluding Mexico, consisting of approximately 6.5 million square feet.

Item 3—Legal Proceedings

See discussion of Legal Proceedings in Note 10 to the consolidated financial statements included in Item 8 of this Report.

Item 4—Submission of Matters to a Vote of Security Holders

Our annual meeting is scheduled for 4:00 p.m. on January 29, 2008, at the Meydenbauer Center in Bellevue, Washington. Matters to be voted on will be included in our proxy statement to be filed with the SEC and distributed to stockholders prior to the meeting.

 

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PART II

Item 5—Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The following table sets forth information on our common stock repurchase program activity for the fourth quarter of fiscal 2007 (amounts in thousands, except per share data):

 

Period(1)

   Total
Number of
Shares
Purchased
   Average
Price Paid
per Share
   Total Number of
Shares Purchased
as Part of Publicly
Announced
Program(2)
   Maximum Dollar
Value of Shares that
May Yet be
Purchased Under
the Program(2)
 

May 14–June 10, 2007

   2,722    $ 55.72    2,722    $ 953,637  

June 11–July 8, 2007

   1,655      56.70    1,655      859,839  

July 9–August 5, 2007

   1,581      60.49    1,581      764,219  

August 6–September 2, 2007

   1,956      60.25    1,956      646,364 (3)
                   

Total Fourth Quarter

   7,914    $ 58.00    7,914   
                   

(1) Monthly information is presented by reference to our fiscal periods during the fourth quarter of fiscal 2007.

 

(2) Our stock repurchase program is conducted under authorizations made by our Board of Directors. The amounts reported in the table are covered by a Board authorization to repurchase shares of common stock of $2 billion authorized in July 2006 and expiring in July 2009.

 

(3) Subsequent to the end of fiscal 2007, our Board of Directors authorized an additional $300 million share repurchase program, expiring in August 2010.

Market Information and Dividend Policy

Our common stock is traded on the National Market tier of the NASDAQ Stock Market LLC (“NASDAQ”) under the symbol “COST.” On October 5, 2007 we had 8,257 stockholders of record.

The following table shows the quarterly high and low closing sale prices as reported by NASDAQ for each quarter during the last two fiscal years and the quarterly cash dividend declared per share of our common stock during the periods indicated.

 

     Price Range   

Cash
Dividends
Declared

     High    Low   

Fiscal 2007:

        

Fourth Quarter

   $ 64.95    $ 54.21    $ 0.145

Third Quarter

     58.28      52.53      0.145

Second Quarter

     57.90      52.20      0.130

First Quarter

     53.90      47.19      0.130

Fiscal 2006:

        

Fourth Quarter

     57.58      46.79      0.130

Third Quarter

     56.70      50.11      0.130

Second Quarter

     51.00      48.29      0.115

First Quarter

     50.14      41.36      0.115

Payment of future dividends is subject to declaration by the Board of Directors. Factors considered in determining the size of the dividends are our profitability and expected capital needs. Subject to these qualifications, we presently expect to continue to pay dividends on a quarterly basis.

Equity Compensation Plans

Information related to our equity compensation plans is incorporated herein by reference to the Proxy Statement. The Proxy Statement will be filed with the SEC within 120 days of the end of our fiscal year.

 

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Table of Contents

Item 6—Selected Financial Data

The following selected financial and operating data are derived from our consolidated financial statements and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included in Item 7 and our consolidated financial statements included in Item 8.

SELECTED FINANCIAL DATA

(dollars in thousands, except per share and warehouse data)

 

As of and for the fiscal year ended(1)   Sept. 2, 2007
(52 weeks)
    Sept. 3, 2006
(53 weeks)
    Aug. 28, 2005
(52 weeks)
    Aug. 29, 2004
(52 weeks)
    Aug. 31, 2003
(52 weeks)
 

RESULTS OF OPERATION

         

Net sales

  $ 63,087,601     $ 58,963,180     $ 51,879,070     $ 47,148,627     $ 41,694,561  

Merchandise costs

    56,449,702       52,745,497       46,346,961       42,092,016       37,235,383  
                                       

Gross Margin

    6,637,899       6,217,683       5,532,109       5,056,611       4,459,178  

Membership fees

    1,312,554       1,188,047       1,073,156       961,280       852,853  

Operating income

    1,608,586       1,625,632       1,474,303       1,385,648       1,156,628  

Net income

    1,082,772       1,103,215       1,063,092       882,393       721,000  

Net income per diluted share

    2.37       2.30       2.18       1.85       1.53  

Dividends per share

  $ 0.55     $ 0.49     $ 0.43     $ 0.20     $  

Increase in comparable warehouse sales(2)

         

United States

    5 %     7 %     6 %     9 %     4 %

International

    9 %     11 %     11 %     14 %     10 %
                                       

Total

    6 %     8 %     7 %     10 %     5 %
                                       

BALANCE SHEET DATA

         

Net property and equipment

  $ 9,519,780     $ 8,564,295     $ 7,790,192     $ 7,219,829     $ 6,960,008  

Total assets

    19,606,586       17,495,070       16,665,205       15,092,548       13,191,688  

Short-term borrowings

    53,832       41,385       54,356       21,595       47,421  

Current portion of long-term debt

    59,905       308,523       3,225       305,594       7,051  

Long-term debt, excluding current portion

    2,107,978       215,369       710,675       993,746       1,289,649  

Stockholders’ equity

  $ 8,623,341     $ 9,143,439     $ 8,881,109     $ 7,624,810     $ 6,554,980  

WAREHOUSE INFORMATION

         

Warehouses in Operation(3)

         

Beginning of year

    458       433       417       397       374  

Opened(4)

    30       28       21       20       29  

Closed(4)

          (3 )     (5 )           (6 )
                                       

End of Year

    488       458       433       417       397  
                                       

(1) Certain reclassifications have been made to prior fiscal years to conform to the presentation adopted in the current fiscal year.

 

(2) Includes net sales at warehouses open greater than one year, including relocated locations.

 

(3) Excludes warehouses operated in Mexico through a 50% owned joint venture.

 

(4) Includes relocations.

 

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Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

Our fiscal year ends on the Sunday closest to the end of August. Fiscal years 2007 and 2005 included 52 weeks. Fiscal year 2006 included 53 weeks, with the extra week included in the fiscal fourth quarter.

Key items for fiscal year 2007 included:

 

   

Net sales in fiscal 2007 (52 weeks) increased 7.0% over fiscal 2006 (53 weeks), driven by an increase in comparable sales (sales in warehouses open for at least one year) of 6% and the opening of 30 new warehouses;

 

   

Membership fees for fiscal 2007 increased 10.5%, to $1.31 billion, primarily due to the $5 increase in our annual membership fee in 2006 for our non-Executive members;

 

   

Gross margin (net sales less merchandise costs) as a percentage of net sales decreased 3 basis points over the prior year;

 

   

Selling, general and administrative (SG&A) expenses as a percentage of net sales increased 22 basis points over the prior year;

 

   

Net income for fiscal 2007 was $1.08 billion, or $2.37 per diluted share, compared to $1.10 billion, or $2.30 per diluted share, in fiscal 2006;

 

   

On February 20, 2007, we issued $900 million of 5.3% Senior Notes due March 15, 2012 and $1.1 billion of 5.5% Senior Notes due March 15, 2017;

 

   

The Board of Directors approved an increase in the quarterly cash dividend from $0.13 to $0.145 per share in April 2007; and

 

   

We repurchased 36.4 million shares of our common stock, expending approximately $1.98 billion at an average cost of $54.39 per share.

Results of Operations (dollars in thousands, except per share and warehouse number data)

The following unusual items impacted fiscal 2007 results:

 

   

Sales returns reserve: In connection with changes to our consumer electronics returns policy, we completed a review of historical data of trends in sales returns, which indicated a longer timeframe over which returns are received than was previously estimated. We revised our estimate of our sales returns reserve to include the longer timeframe, as well as a lower realization rate on certain returned items. The effect of the revisions to our estimated reserve resulted in a decrease in net sales of $452.6 million and a charge to gross margin of approximately $94.3 million.

 

   

Employee tax consequences on stock options: In connection with the review of stock option grants and guidance issued by the U.S. Internal Revenue Service on November 30, 2006, the Compensation Committee of the Board of Directors approved a program intended to protect approximately 1,000 employees who are United States taxpayers from certain adverse tax consequences arising from that review. The program involved increasing the exercise prices on certain stock options granted from 2000 to 2003 and, in turn, making payments to employees in an amount approximately equal to the increase in the exercise price. While we are still examining the availability of similar alternatives for employees outside the United States, we recorded a charge in fiscal 2007 for the estimated amount to remedy adverse tax consequences related to stock options held and previously exercised by employees outside the United States. In aggregate, these charges totaled $47.3 million.

 

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Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

 

   

Excise tax refund: We received a $10.1 million refund, related to fiscal 2002 through fiscal 2006, as a result of a settlement with the U.S. Internal Revenue Service relating to excise taxes previously paid.

 

   

Deferred membership: In the fourth quarter of fiscal 2007, we performed a detailed analysis of the timing of recognition of membership fees based on each member’s specific renewal date (daily convention) as this methodology represented an improvement over our historical method (based on the period in which the fee was collected). This review resulted in a $56.2 million reduction to membership fee revenue and a corresponding increase to deferred membership fees on our consolidated balance sheet. This adjustment includes both a change in method of applying an accounting principle to a preferable method and a correction for cumulative timing errors. Prospectively, we will account for membership fee revenue on a deferred basis over the specific membership term using the daily convention.

We believe it is helpful to disclose the effects of these items for purposes of providing a meaningful comparison of our current fiscal year results to prior fiscal years, as well as provide a more representative expectation of future operating results. The impact of each of these items noted above is presented below:

 

     Fiscal 2007 (amounts in thousands)  
     Sales return
reserve
    Employee tax
consequences on
stock options
    Deferred
Membership
    Excise tax
refund
    Total  

Net sales

   $ (452,553 )   $     $         $ (452,553 )

Membership fees

     —               (56,183 )         (56,183 )
                                      

Total revenue

     (452,553 )           (56,183 )         (508,736 )

Merchandise costs

     358,290       (157 )         8,661       366,794  
                                      

Gross margin(1)

     (94,263 )     (157 )         8,661       (85,759 )

SG&A

           (47,115 )         300       (46,815 )
                                      

Operating income

     (94,263 )     (47,272 )     (56,183 )   8,961       (188,757 )

Interest expense

           (50 )               (50 )

Interest income and other

     (1,000 )               1,090       90  
                                      

Income before income taxes

     (95,263 )     (47,322 )     (56,183 )   10,051       (188,717 )

Provision for income taxes

     34,942       17,358       20,608     (3,687 )     69,221  
                                      

Net Income

   $ (60,321 )     (29,964 )   $ (35,575 )   6,364     $ (119,496 )
                                      

(1) Net sales less merchandise costs.

Net Sales

 

     Fiscal 2007     Fiscal 2006     Fiscal 2005  

Net sales

   $ 63,087,601     $ 58,963,180     $ 51,879,070  

Effect of change in estimated sales returns reserve

     452,553              
                        

Net sales, as adjusted

   $ 63,540,154     $ 58,963,180     $ 51,879,070  

Net sales increase

     7.0 %     13.7 %     10.0 %

Net sales increase, as adjusted

     7.8 %     13.7 %     10.0 %

Increase in comparable warehouse sales

     6 %     8 %     7 %

Warehouse openings, net of relocations

     30       25       16  

 

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Table of Contents

Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

 

2007 vs. 2006

Net sales increased $4.13 billion, or 7.0% to $63.09 billion in fiscal 2007 (a 52-week fiscal year) from $58.96 billion in fiscal 2006 (a 53-week fiscal year). The $4.13 billion increase in net sales is comprised of $2.10 billion from the increase in comparable warehouse sales and $2.03 billion from sales at new warehouses opened during fiscal 2007 and 2006, partially offset by the change in the reserve for estimated sales returns.

Changes in prices of merchandise did not materially affect the sales increase. Gasoline sales contributed to the $4.13 billion net sales growth by approximately $356.1 million, with approximately $17.8 million of this increase related to the increase in gasoline sales prices.

Most of the comparable sales growth derived from increased amounts spent by members visiting our warehouses, while increases in frequency of shopping contributed slightly. Reported comparable sales growth includes the negative impact of cannibalization (established warehouses losing sales to our newly opened locations). Gasoline sales did not have a material impact on comparable warehouse sales growth. Changes in foreign currencies positively impacted comparable sales by approximately $418.4 million, or 72 basis points.

In our fourth fiscal quarter, the decrease in our estimated sales returns reserve resulted in an increase to net sales of $57.9 million as compared to the fourth quarter of fiscal 2006 where our reserve was increased, resulting in a decrease to net sales of $33.1 million. This improvement is primarily a result of the changes to our consumer electronics returns policy implemented in the spring of 2007.

2006 vs. 2005

Net sales increased 13.7% to $58.96 billion in fiscal 2006, from $51.88 billion in fiscal 2005. The increase in net sales was primarily due to: 8% from comparable warehouse sales growth; 3.7% increase primarily from warehouse sales excluded from the comparable warehouse sales calculation; and 2% from an additional week in fiscal 2006 as compared to the prior year. Gasoline sales positively impacted comparable warehouse sales growth by approximately 150 basis points. Changes in foreign currencies positively impacted comparable sales by approximately 90 basis points.

Most of the comparable sales growth was derived from increased amounts spent by members visiting our warehouses, while increases in frequency of shopping contributed slightly. Comparable sales growth was slightly offset by cannibalization (established warehouses losing sales to our newly opened locations).

Changes in prices of merchandise, with the exception of gasoline, did not materially affect the sales increase. Gasoline sales contributed to the 13.7% net sales growth by approximately 235 basis points in fiscal 2006, with approximately 70% of this increase related to the increase in gasoline sales prices.

Membership Fees

 

    Fiscal 2007     Fiscal 2006     Fiscal 2005  

Membership fees

  $ 1,312,554     $ 1,188,047     $ 1,073,156  

Adjustment to deferred membership balance

    56,183              
                       

Membership fees, as adjusted

  $ 1,368,737     $ 1,188,047     $ 1,073,156  

Membership fees increase

    10.5 %     10.7 %     11.6 %

Membership fees increase, as adjusted

    15.2 %     10.7 %     11.6 %

Membership fees as a percent of net sales

    2.08 %     2.02 %     2.07 %

Adjusted membership fees, as a percent of adjusted net sales

    2.16 %     2.02 %     2.07 %

Total cardholders

    50,400       47,700       45,300  

 

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Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

 

2007 vs. 2006

Membership fees increased 10.5% to $1.31 billion, or 2.08% of net sales, in fiscal 2007 from $1.19 billion, or 2.02% of net sales, in fiscal 2006. Excluding the adjustment to deferred membership fees in the fourth quarter of fiscal 2007 discussed above, adjusted membership fees increased 15.2% from fiscal 2006. This increase was primarily due to: a five dollar increase in our annual membership fee for our U.S. and Canada Gold Star (individual), Business and Business Add-on members, which was effective May 1, 2006 for new members and July 1, 2006 for existing members; increased penetration of the higher-fee Executive Membership program; and additional membership sign-ups at the 30 new warehouses opened in fiscal 2007.

2006 vs. 2005

Membership fees increased 10.7% to $1.19 billion, or 2.02% of net sales, in fiscal 2006 from $1.07 billion, or 2.07% of net sales, in fiscal 2005. This increase was primarily due to increased penetration of the Executive Membership program and additional membership sign-ups at the 25 new warehouses opened in fiscal 2006.

Gross Margin

 

     Fiscal 2007     Fiscal 2006     Fiscal 2005  

Gross margin

   $ 6,637,899     $ 6,217,683     $ 5,532,109  

Unusual items

     85,759              
                        

Gross margin, as adjusted

   $ 6,723,658     $ 6,217,683     $ 5,532,109  

Gross margin increase

     6.8 %     12.4 %     9.4 %

Gross margin increase, as adjusted

     8.1 %     12.4 %     9.4 %

Gross margin as a percent of net sales

     10.52 %     10.55 %     10.66 %

Adjusted gross margin as a percent of adjusted net sales

     10.58 %     10.55 %     10.66 %

2007 vs. 2006

Gross margin was $6.64 billion in fiscal 2007 or 10.52% of net sales, compared to $6.22 billion or 10.55% of net sales in fiscal 2006. Excluding the unusual items affecting net sales and gross margin in fiscal 2007, adjusted gross margin as a percentage of adjusted net sales was 10.58%, or an increase of 3 basis points as compared to fiscal 2006. This increase was primarily due to a 24 basis point increase in certain merchandise departments, largely food and sundries, as well as smaller increases in certain warehouse ancillary businesses, costco.com and our international operations, offset by a decrease in our hardlines and softlines categories of approximately 15 basis points. In addition, increased penetration of the Executive Membership two-percent reward program and increased spending by Executive members negatively affected gross margin by six basis points.

In our fourth fiscal quarter, the decrease in our reserve for estimated sales returns resulted in an improvement of gross margin of approximately 2 basis points. This improvement is primarily a result of the changes to our consumer electronics returns policy implemented in the spring of 2007.

2006 vs. 2005

Gross margin was $6.22 billion in fiscal 2006 or 10.55% of net sales, compared to $5.53 billion or 10.66% of net sales in fiscal 2005. This eleven basis point decrease reflected increased penetration of

 

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Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

 

the Executive Membership two-percent reward program and increased spending by executive members, which decreased gross margin by ten basis points. Additionally, a decrease of four basis points in gross margin in our merchandise departments and warehouse ancillary businesses was primarily due to changes in the sales mix, with higher sales penetration of lower margin departments and slightly lower overall gross margins in our hardlines and softlines categories. These decreases were partially offset by a three basis point improvement related to valuing inventories following the last-in-first-out (LIFO) method.

Selling, General and Administrative Expenses

 

     Fiscal 2007     Fiscal 2006     Fiscal 2005  

Selling, general and administrative expense (SG&A)

   $ 6,273,096     $ 5,732,141     $ 5,061,339  

Unusual items

     (46,815 )            
                        

SG&A, as adjusted

   $ 6,226,281     $ 5,732,141     $ 5,061,339  

SG&A a percent of net sales

     9.94 %     9.72 %     9.76 %

Adjusted SG&A as percent of adjusted net sales

     9.80 %     9.72 %     9.76 %

2007 vs. 2006

SG&A expenses were $6.27 billion, or 9.94% of net sales in fiscal 2007, compared to $5.73 billion, or 9.72% of net sales in fiscal 2006. Excluding the unusual items affecting net sales and SG&A expenses in fiscal 2007, adjusted SG&A as a percentage of adjusted net sales was 9.80%, an increase of eight basis points. Of this increase, 3 basis points were primarily due to an increase in stock-based compensation, and a net 5 basis points were due to an increase in warehouse payroll and benefits costs. The payroll increase was largely attributed to hourly rate increases that went into effect in March 2007 and a lower overall comparable warehouse sales increase.

2006 vs. 2005

SG&A expenses were $5.73 billion, or 9.72% of net sales in fiscal 2006, compared to $5.06 billion, or 9.76% of net sales in fiscal 2005. Improved warehouse and central operating costs positively impacted SG&A by approximately nine basis points, primarily due to increased expense leverage of warehouse payroll, which was positively impacted by strong comparable warehouse sales and a lower rate of increase in workers’ compensation costs. This improvement was partially offset by an increase in stock-based compensation cost of approximately five basis points in fiscal 2006.

Preopening Expenses

 

     Fiscal 2007    Fiscal 2006     Fiscal 2005  

Preopening expenses

   $ 55,163    $ 42,504     $ 53,230  

Warehouse openings

     30      28       21  

Relocations

          (3 )     (5 )
                       

Warehouse openings, net of relocations

     30      25       16  
                       

Preopening expenses include costs incurred for startup operations related to new warehouses, warehouse remodel projects and the expansion of ancillary operations at existing warehouses. Preopening

 

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Table of Contents

Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

 

expenses per warehouse opening can vary due to the timing of the opening relative to our fiscal year end, whether the warehouse is owned or leased, whether the opening is in an existing, new or international market and the number and magnitude of warehouse remodel projects.

2007 vs. 2006

Preopening expenses totaled $55.2 million in fiscal 2007 compared to $42.5 million in fiscal 2006. This increase is primarily due to increased warehouse remodel activity and international openings.

2006 vs. 2005

Preopening expenses totaled $42.5 million in fiscal 2006 compared to $53.2 million in fiscal 2005. During fiscal 2005, we adjusted our method of accounting for leases (entered into over the previous twenty years), primarily related to ground leases at certain owned warehouse locations that did not require rental payments during the period of construction. We recorded a cumulative pre-tax, non-cash charge of $16.0 million to preopening expenses in the second quarter of fiscal 2005. Excluding this charge, preopening expenses increased year over year, due to the increase in warehouse openings.

Provision for Impaired Assets and Closing Costs, net

 

     Fiscal 2007     Fiscal 2006    Fiscal 2005

Provision for impaired assets and closing costs, net:

       

Warehouse closing expenses

   $ 15,887     $ 3,762    $ 11,619

Impairment of long-lived assets

                3,893

Net (gains) losses on the sale of real property

     (2,279 )     1,691      881
                     

Total

   $ 13,608     $ 5,453    $ 16,393
                     

The provision primarily includes costs related to impairment of long-lived assets, future lease obligations of warehouses that have been relocated to new facilities, accelerated depreciation on buildings to be demolished or sold and that are not otherwise impaired, and losses or gains resulting from the sale of real property.

2007 vs. 2006

The net provision for impaired assets and closing costs was $13.6 million in fiscal 2007, compared to $5.5 million in fiscal 2006. In fiscal 2007, approximately $13.0 million of this provision related to the acceleration of depreciation on ten buildings expected to be relocated in fiscal 2008.

2006 vs. 2005

The net provision for impaired assets and closing costs was $5.5 million in fiscal 2006, compared to $16.4 million in fiscal 2005. The provision for fiscal 2006 included charges of $3.8 million for warehouse closing expenses and $1.7 million for net losses on the sale of real property. The provision for fiscal 2005 included charges of $11.6 million for warehouse closing expenses, primarily related to lease obligations and accelerated building depreciation, $3.9 million for impairment of long-lived assets, and $0.9 million for net losses on the sale of real property.

 

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The reserve for warehouse closing costs, classified within other current liabilities, at the end of fiscal 2007 and 2006 included:

 

     September 2,
2007
   September 3,
2006

Reserve for warehouse closing costs:

     

Future lease obligations

   $ 6,086    $ 5,950

Other

     737      1,091
             

Total

   $ 6,823    $ 7,041
             

Interest Expense

 

     Fiscal 2007    Fiscal 2006    Fiscal 2005

Interest expense

   $ 64,079    $ 12,570    $ 34,437

2007 vs. 2006

Interest expense totaled $64.1 million in fiscal 2007, compared to $12.6 million in fiscal 2006. On February 20, 2007, we issued $900 million of 5.3% Senior Notes due March 15, 2012 (2012 Notes) at a discount of $2.5 million and $1.1 billion of 5.5% Senior Notes due March 15, 2017 (2017 Notes) at a discount of $5.9 million, (together the 2007 Senior Notes). The increase in interest expense for fiscal 2007 resulted primarily from the additional interest incurred related to the 2007 Senior Notes, offset by lower interest expense resulting from the repayment of the $300 million 5.5% Senior Notes (2002 Senior Notes) in March 2007. In addition, interest expense decreased on the 3.5% Zero Coupon Convertible Subordinated Notes (Zero Coupon Notes) as note holders converted approximately $61.2 million in principal amount of the Zero Coupon Notes into common stock, or $42.3 million after factoring in the related debt discount.

2006 vs. 2005

Interest expense totaled $12.6 million in fiscal 2006, compared to $34.4 million in fiscal 2005. Interest expense in fiscal 2006 primarily included interest on the 2002 Senior Notes, the Zero Coupon Notes, and balances outstanding under our bank credit facilities and promissory notes. In fiscal 2005, interest expense also included interest on the 7 1/8% Senior Notes. The decrease in interest expense in fiscal 2006 resulted primarily from the repayment of the 7 1/8% Senior Notes in June 2005. In addition, interest expense decreased on the Zero Coupon Notes as note holders converted into common stock approximately $286.5 million in principal amount of the Zero Coupon Notes, or $188.9 million after factoring in the related debt discount. The amount of interest capitalized increased in fiscal 2006 due to increased warehouse openings, contributing to the decrease in interest expense, as both interest rates and the dollar amount of projects under construction increased. The overall decrease in interest expense in fiscal 2006 was partially offset by the increase in interest rates on the 2002 Senior Notes, which were swapped into variable rate debt in March 2002.

Interest Income and Other

 

     Fiscal 2007    Fiscal 2006     Fiscal 2005

Interest income

   $ 128,413    $ 113,712     $ 81,915

Earnings of affiliates

     35,622      28,180       26,459

Minority interest and other

     1,449      (3,537 )     722
                     

Interest Income and other

   $ 165,484    $ 138,355     $ 109,096
                     

 

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2007 vs. 2006

Interest income and other totaled $165.5 million in fiscal 2007, compared to $138.4 million in fiscal 2006. This increase is largely due to the increase in our cash and cash equivalents and short-term investments resulting from increased earnings from operations and the proceeds of the issuance of the 2007 Senior Notes, as well as an increase in the earnings of affiliates, primarily our investment in Costco Mexico (a 50%-owned joint venture).

2006 vs. 2005

Interest income and other totaled $138.4 million in fiscal 2006, compared to $109.1 million in fiscal 2005. This increase primarily reflects increased interest income resulting from higher interest rates earned, as well as an extra week in fiscal 2006 as compared to fiscal 2005.

Provision for Income Taxes

 

     Fiscal 2007     Fiscal 2006     Fiscal 2005  

Income tax expense

   $ 627,219     $ 648,202     $ 485,870  

Effective tax rate

     36.68 %     37.01 %     31.37 %

The effective income tax rate on earnings in fiscal 2007, 2006 and 2005 was 36.68%, 37.01% and 31.37%, respectively. The lower rate in fiscal 2005 was primarily attributable to a non-recurring $54.2 million income tax benefit, primarily from the settlement of a transfer pricing dispute between the United States and Canada (covering the years 1996-2003) and a net tax benefit on excess foreign tax credits on unremitted foreign earnings subject to repatriation of $20.6 million. Excluding these benefits the effective income tax rate on earnings in fiscal 2005 would have been 36.20%.

Net Income

 

     Fiscal 2007     Fiscal 2006     Fiscal 2005  

Net income

   $ 1,082,772     $ 1,103,215     $ 1,063,092  

Unusual items (net of tax)

     119,496              
                        

Net income, as adjusted

   $ 1,202,268     $ 1,103,215     $ 1,063,092  

Diluted earnings per share

   $ 2.37     $ 2.30     $ 2.18  

Shares used to calculate diluted net income per common share

     457,641       480,341       492,035  

Diluted earnings per share increase

     3 %     6 %     18 %

2007 vs. 2006

Net income for fiscal 2007 was $1.08 billion, or $2.37 per diluted share, compared to $1.10 billion, or $2.30 per diluted share, during fiscal 2006. During fiscal 2007, we repurchased 36.4 million shares of common stock, favorably impacting earnings per diluted share by approximately $0.03. The unusual items previously discussed totaled $119.5 million, net of tax, or $0.26 per diluted share in fiscal 2007. Exclusive of these items, earnings for fiscal 2007 were $2.63 per diluted share, a 14% increase over the prior year.

 

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2006 vs. 2005

Net income for fiscal 2006 increased 3.8%, to $1.10 billion or $2.30 per diluted share, from $1.06 billion or $2.18 per diluted share, during fiscal 2005. During fiscal 2006, we repurchased 28.4 million shares of common stock, favorably impacting earnings per diluted share by approximately $0.02. The fiscal 2005 results included several non-recurring items that in the aggregate positively impacted reported earnings for all of fiscal 2005 by approximately $0.14 per share: a $54.2 million (approximately $0.11 per diluted share) income tax benefit resulting primarily from the settlement of a transfer pricing dispute between the United States and Canada; a cumulative pre-tax, non-cash charge to preopening expenses of $16.0 million (approximately $0.02 per diluted share) related to a correction to our method of accounting for ground leases; and a net tax benefit with respect to excess foreign tax credits on unremitted foreign earnings recorded in the fourth quarter of $20.6 million (approximately $0.04 per diluted share). Exclusive of these items, fiscal 2005 earnings were $2.04 per diluted share. Fiscal 2006’s earnings per diluted share represents an increase of 13% over that figure.

Liquidity and Capital Resources

The following table itemizes our most liquid assets (dollars in thousands):

 

     September 2,
2007
   September 3,
2006

Cash and cash equivalents

   $ 2,779,733    $ 1,510,939

Short-term investments

     575,787      1,322,181
             

Total

   $ 3,355,520    $ 2,833,120
             

Our primary sources of liquidity are cash flows generated from warehouse operations and our existing cash and cash equivalents and short-term investments balances, which were $3.36 billion and $2.83 billion at September 2, 2007 and September 3, 2006, respectively. Of these balances, approximately $655.2 million and $593.6 million at September 2, 2007 and September 3, 2006, respectively, represented debit and credit card receivables, primarily related to weekend sales immediately prior to the year-end close. The increase in our most liquid assets of $522.4 million to $3.36 billion at September 2, 2007 was due primarily to the issuance of the 2007 Senior Notes and the cash provided by our operating activities, offset by expenditures for the repurchase of our common stock and the acquisition of property and equipment related to warehouse expansion.

Net cash provided by operating activities totaled $2.08 billion in fiscal 2007 compared to $1.83 billion in fiscal 2006, an increase of $245.2 million. This increase was primarily attributable to an increase in cash flow due to a decrease in our investment in net merchandise inventories (merchandise inventory less accounts payable) of $378.8 million, offset by a decrease in cash flow from operating assets and liabilities of $130.4 million.

Net cash used in investing activities totaled $655.3 million in fiscal 2007 compared to $1.16 billion in fiscal 2006, respectively, a decrease of approximately $502.2 million. The decrease in cash used in investing activities relates primarily to an increase of $169.2 million in additions to property and equipment related to warehouse expansion and remodel projects, offset by an increase in cash provided by the net reductions in short-term investments of $663.8 million.

Net cash used in financing activities totaled $164.6 million in fiscal 2007 compared to $1.23 billion in fiscal 2006. The $1.1 billion decrease in net cash used in financing activities was primarily due to the issuance of the 2007 Senior Notes in February 2007, which provided approximately $1.99 billion in

 

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proceeds. This was partially offset by the repurchase of common stock in fiscal 2007, which used $1.98 billion of cash, compared to $1.44 billion in fiscal 2006, an increase of approximately $534.8 million and the repayment of long-term debt of $307.9 million related primarily to the 2002 Senior Notes retired in March 2007.

Dividends

In April 2007, our Board of Directors increased our quarterly cash dividend from $0.13 to $0.145 per share or $0.58 on an annualized basis. Our quarterly cash dividends paid in fiscal 2007 totaled $0.55 per share. In fiscal 2006, we paid quarterly cash dividends totaling $0.49 per share.

Contractual Obligations

Our commitments at fiscal year end to make future payments under contractual obligations were as follows, as of September 2, 2007 (amounts in thousands):

 

     Payments Due by Fiscal Year
      2008    2009 to
2010
   2011 to
2012
   2013 and
thereafter
   Total

Contractual obligations

              

Purchase obligations (merchandise)(1)

   $ 3,626,627    $ 1,357    $    $    $ 3,627,984

Long-term debt(2)

     173,160      277,652      1,116,400      1,470,117      3,037,329

Operating leases(3)

     137,225      242,461      209,723      1,305,035      1,894,444

Purchase obligations (equipment, services and other)(4)

     350,108      40,517      1,089           391,714

Construction Commitments

     329,941                     329,941

Capital lease obligations and other(2)

     3,990      1,937      686      5,193      11,806

Other(5)

     2,168      3,936      2,546      4,928      13,578
                                  

Total

   $ 4,623,219    $ 567,860    $ 1,330,444    $ 2,785,273    $ 9,306,796
                                  

(1) Includes open merchandise purchase orders.

 

(2) Amounts include contractual interest payments.

 

(3) Operating lease obligations exclude amounts commonly referred to as common area maintenance, taxes and insurance and have been reduced by $149,407 to reflect sub-lease income.

 

(4) The amounts exclude certain services negotiated at the individual warehouse or regional level that are not significant and generally contain clauses allowing for cancellation without significant penalty.

 

(5) Consists of asset retirement and deferred compensation obligations.

Expansion Plans

Our primary requirement for capital is the domestic and international financing of land, building and equipment costs for new and remodeled warehouses, plus the costs of initial warehouse operations and working capital requirements.

While there can be no assurance that current expectations will be realized and plans are subject to change upon further review, it is management’s current intention to spend approximately $1.6 billion to

 

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$1.8 billion during fiscal 2008 for real estate, construction, remodeling and equipment for warehouse clubs and related operations. These expenditures are expected to be financed with a combination of cash provided from operations and the use of cash and cash equivalents and short-term investments.

Plans for the United States and Canada during fiscal 2008 are to open approximately 38 to 42 new warehouses, inclusive of 8 to 10 relocations to larger and better-located facilities. We expect to continue our review of expansion plans in our international operations, including the United Kingdom and Asia, along with other international markets.

Additional Equity Investments in Subsidiaries and Joint Ventures

In each of fiscal years 2006 and 2005, we contributed an additional $15 million to our investment in Costco Mexico (a 50%-owned joint venture), which did not impact our percentage ownership of this entity, as our joint venture partner contributed a like amount. There were no such contributions in 2007.

Bank Credit Facilities and Commercial Paper Programs (all amounts stated in U.S. dollars)

A wholly-owned Canadian subsidiary has a $189.8 million commercial paper program ($180.9 million at September 3, 2006) supported by a $113.9 million bank credit facility that expires in March 2008 ($54.2 million at September 3, 2006) with a Canadian bank, which we guarantee. At September 2, 2007 and September 3, 2006, no amounts were outstanding under the Canadian commercial paper program or the bank credit facility. Applicable interest rates on the credit facility at September 2, 2007, and September 3, 2006 were 5.00% and 4.65%, respectively. At September 2, 2007, standby letters of credit totaling $24.1 million issued under the bank credit facility left $89.8 million available for commercial paper support. At September 3, 2006, standby letters of credit totaling $20.8 million issued under the bank credit facility left $33.4 million available for commercial paper support.

Our wholly-owned Japanese subsidiary has a short-term $38.7 million bank line of credit ($12.8 million at September 3, 2006) that expires in February 2008. At September 2, 2007 and September 3, 2006, $10.3 million and $2.5 million, respectively, were borrowed under the line of credit, and $8.6 million and $4.3 million, respectively, were used to support standby letters of credit. Applicable interest rates on the credit facility at September 2, 2007 and September 3, 2006, were 1.09% and 0.94%, respectively. A second $30.1 million bank line of credit also expires in February 2008. At September 2, 2007 and September 3, 2006, $7.8 million and $0.9 million, respectively, were borrowed under the second facility. Applicable interest rates on the second credit facility at September 2, 2007 and September 3, 2006, were 1.10% and 0.95%, respectively.

Our Korean subsidiary has a short-term $12.8 million bank line of credit ($12.5 million at September 3, 2006) which expires in March 2008. At September 2, 2007 and September 3, 2006, no amounts were borrowed under the line of credit and $2.0 million in both years was used to support standby letters of credit. Applicable interest rates on the credit facility at September 2, 2007 and September 3, 2006 were 6.09% and 5.48%, respectively.

Our Taiwan subsidiary has a $6.1 million bank revolving credit facility ($5.2 million at September 3, 2006) and a $3.0 million bank overdraft facility, both expiring in January 2008. At September 2, 2007 and September 3, 2006, no amounts were borrowed under the credit facility and $1.2 million and $1.9 million, respectively, were used to support standby letters of credit. Applicable interest rates on the credit facility at September 2, 2007 and September 3, 2006, were 4.50% and 4.00%, respectively. A second $15.2 million bank revolving credit facility is in place, which expires in July 2008. At September 2, 2007 and September 3, 2006, no amounts were borrowed under the second credit facility

 

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and $4.2 million and $2.0 million, respectively, were used to support standby letters of credit. Applicable interest rates on the credit facility at September 2, 2007 and September 3, 2006, were 4.44% and 4.00%, respectively. A third $9.1 million bank revolving credit facility is in place, which expires in March 2008. At September 2, 2007 no amounts were borrowed under the third credit facility and no amounts were used to support standby letters of credit. The applicable interest rate on the credit facility at September 2, 2007 was 4.57%.

Our wholly-owned United Kingdom subsidiary has a $80.6 million bank revolving credit facility ($113.9 million at September 3, 2006) expiring in February 2010, a $70.5 million bank overdraft facility ($66.5 million at September 3, 2006), renewable on a yearly basis in May 2008, and a $40.3 million uncommitted money market line entered into in February 2007 and renewable on a yearly basis beginning in May 2008. At September 2, 2007, $20.1 million was outstanding under the revolving credit facility with an applicable interest rate of 6.23%, $15.6 million was outstanding under the uncommitted line with an applicable interest rate of 6.47% and no amounts were outstanding under the bank overdraft facility with an applicable interest rate of 6.75%. At September 3, 2006, $38.0 million was outstanding under the revolving credit facility, with an applicable interest rate of 5.32%, and no amounts were outstanding under the bank overdraft facility.

Letters of Credit

We have letter of credit facilities (for commercial and standby letters of credit) totaling $475.0 million. The outstanding commitments under these facilities at September 2, 2007 and September 3, 2006 totaled $119.1 million and $84.9 million, respectively, including $71.7 million and $54.9 million, respectively, in standby letters of credit.

Financing Activities

On February 20, 2007, we issued $900 million of 5.3% Senior Notes due March 15, 2012 at a discount of $2.5 million and $1.1 billion of 5.5% Senior Notes due March 15, 2017 at a discount of $5.9 million (together, the 2007 Senior Notes). Interest on the 2007 Senior Notes is payable semi-annually on March 15 and September 15 of each year, with the first payment due on September 15, 2007. The net proceeds were used, in part, to repay the 2002 Senior Notes in March 2007, and the balance has been and will be used for general corporate purposes, including repurchases of our common stock. The $8.4 million discount and $2.0 million issuance costs associated with the 2007 Senior Notes are being amortized to interest expense over the terms of those notes.

At our option, we may redeem the 2007 Senior Notes at any time, in whole or in part, at a redemption price plus accrued interest up to the redemption date. The redemption price is equal to the greater of 100% of the principal amount of the 2007 Senior Notes to be redeemed, or the sum of the present values of the remaining scheduled payments of principal and interest to maturity. Additionally, we will be required to make an offer to purchase the 2007 Senior Notes at a price of 101% of the principal amount plus accrued and unpaid interest to the date of repurchase, upon certain events as defined by the terms of the 2007 Senior Notes.

In April 2003, our wholly-owned Japanese subsidiary issued promissory notes bearing interest at 0.92% in the aggregate amount of $34.4 million, through a private placement. Interest is payable semi-annually and principal is due in April 2010. In November 2002, our wholly-owned Japanese subsidiary issued promissory notes bearing interest at 0.88% in the aggregate amount of $25.8 million, through a private placement. Interest is payable semi-annually and principal is due in November 2009. In July

 

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2001, our wholly-owned Japanese subsidiary issued 1.187% promissory notes in the aggregate amount of $25.8 million, through a private placement. Interest is payable semi-annually and principal is due in July 2008. In October 2000, our wholly-owned Japanese subsidiary issued 2.070% promissory notes in the aggregate amount of $30.1 million, through a private placement. Interest is payable annually and principal is due in October 2007 and will be refinanced. As of September 2, 2007, the 1.187% and the 2.070% promissory notes are reported in the current portion of long-term debt on our consolidated balance sheets.

In August 1997, we completed the sale of $900.0 million principal amount at maturity Zero Coupon Notes due in August 2017. The Zero Coupon Notes were priced with a yield to maturity of 3.5%, resulting in gross proceeds to us of $449.6 million. The current Notes outstanding are convertible into a maximum of 1.5 million shares of Costco Common Stock shares at an initial conversion price of $22.71. Holders of the Zero Coupon Notes may require us to purchase the Zero Coupon Notes (at the discounted issue price plus accrued interest to date of purchase) in August 2012. We may redeem, at our option, the Zero Coupon Notes (at the discounted issue price plus accrued interest to date of redemption) any time in or after August 2002. As of September 2, 2007, $832.4 million in principal amount of the Zero Coupon Notes had been converted by note holders to shares of Costco Common Stock, of which $61.2 million and $286.5 million in principal were converted in fiscal 2007 and 2006, respectively, or $42.3 million and $188.9 million in fiscal 2007 and 2006, respectively, after factoring in the related debt discount.

Derivatives

We have limited involvement with derivative financial instruments and use them only to manage well-defined interest rate and foreign exchange risks. Forward foreign exchange contracts are used to hedge the impact of fluctuations of foreign exchange on inventory purchases and typically have very short terms. These forward contracts do not qualify for derivative hedge accounting. The aggregate notional amount, which approximates the fair value of foreign exchange contracts outstanding at September 2, 2007 and September 3, 2006, was $75.0 million and $63.5 million, respectively. The mark-to-market adjustment related to these contracts was $0.9 million and $1.1 million at September 2, 2007 and September 3, 2006, respectively. The majority of the forward foreign exchange contracts were entered into by our wholly-owned United Kingdom subsidiary, primarily to hedge U.S. dollar merchandise inventory purchases.

Effective March 25, 2002, we entered into “fixed-to-floating” interest rate swaps to manage interest rate risk associated with our 2002 Senior Notes, which matured and were retired in March 2007. The swaps were designated and qualified as fair value hedges of the debt. As the terms of the swaps matched those of the underlying hedged debt, changes in the fair value of the swaps were offset by corresponding changes in the carrying amount of the hedged debt and resulted in no net earnings impact. At September 3, 2006, the aggregate value of the swaps was $1 million and was recorded in “deferred income taxes and other current assets” in our consolidated balance sheets. In March 2007, upon maturity of the debt and expiration of the swap agreements, the aggregate fair value of the swaps was zero.

We are exposed to market risk for changes in utility commodity pricing, which we partially mitigate through the use of firm-price contracts with counterparties for approximately 23% of our locations in the U.S. and Canada. The effects of these arrangements are not significant for any period presented.

 

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Off-Balance Sheet Arrangements

With the exception of our operating leases, we have no off-balance sheet arrangements that have had, or are reasonably likely to have, a material current or future effect on our financial condition or consolidated financial statements.

Stock Repurchase Programs

In January and July of 2006, our Board of Directors approved an additional $1.00 billion and $2.00 billion of stock repurchases, respectively, which expire in 2009, bringing total authorizations by our Board of Directors since inception of the program in fiscal 2001 to $4.50 billion. Subsequent to the end of fiscal 2007, our Board of Directors approved an additional $300.0 million of stock repurchases, which expires in 2010.

During fiscal 2007, we repurchased 36.4 million shares at an average price of $54.39 totaling approximately $1.98 billion. During fiscal 2006, we repurchased 28.4 million shares of common stock, at an average price of $51.44, totaling approximately $1.46 billion. The remaining amount available to be purchased under our approved plan was approximately $646.4 million at September 2, 2007. Purchases are made from time-to-time as conditions warrant in the open market or in block purchases, or pursuant to plans under SEC Rule 10b5-1. Repurchased shares are retired.

Critical Accounting Policies

The preparation of our financial statements requires that we make estimates and judgments. We continue to review our accounting policies and evaluate our estimates, including those related to revenue recognition, merchandise inventory valuation, impairment of long-lived assets, warehouse closing costs, insurance/self-insurance liabilities and income taxes. We base our estimates on historical experience and on other assumptions that we believe to be reasonable.

Revenue Recognition

We generally recognize sales, net of estimated returns, at the time the member takes possession of merchandise or receives services. When we collect payment from customers prior to the transfer of ownership of merchandise or the performance of services, the amount received is generally recorded as deferred revenue on the consolidated balance sheets until the sale or service is completed. We provide for estimated sales returns based on historical merchandise returns levels.

In connection with changes to our consumer electronics returns policy in the spring of 2007, we examined operational data regarding member return patterns that had not been previously analyzed. The data indicated a longer timeframe over which returns are received than previously used to estimate the sales return reserve. Accordingly, as previously disclosed, during fiscal 2007 we increased the reserve balance and recorded an adjustment to sales of $452.6 million and a pretax charge to income of $94.3 million for the related gross margin and disposition costs.

We evaluate the criteria of the Financial Accounting Standards Board (FASB) Emerging Issues Task Force (EITF) 99-19, “Reporting Revenue Gross as a Principal Versus Net as an Agent,” in determining whether it is appropriate to record the gross amount of merchandise sales and related costs or the net amount earned as commissions. Generally, when we are the primary obligor, subject to inventory risk, have latitude in establishing prices and selecting suppliers, influence product or service specifications, or have several but not all of these indicators, revenue is recorded on a gross basis. If we are not the

 

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primary obligor and do not possess other indicators of gross reporting as noted above, we record the net amounts as commissions earned, which is reflected in net sales.

Membership fee revenue represents annual membership fees paid by substantially all of our members. We account for membership fee revenue on a deferred basis, whereby membership fee revenue is recognized ratably over one-year. In the fourth quarter of fiscal 2007, we performed a detailed analysis of the timing of recognition of membership fees based on each member’s specific renewal date as this methodology represented an improvement over our historical method, which was based on the period in which the fee was collected. This review resulted in a $56.2 million reduction to membership fee revenue and corresponding increase to deferred membership fees on our consolidated balance sheet. This adjustment includes both a change in method of applying an accounting principle to a preferable method and a correction for cumulative timing errors.

Our Executive members qualify for a 2% reward (which can be redeemed only at Costco warehouses), up to a maximum of $500 per year, on all qualified purchases made at Costco. We account for this 2% reward as a reduction in sales, with the related liability being classified within other current liabilities. The sales reduction and corresponding liability are computed after giving effect to the estimated impact of non-redemptions based on historical data.

Merchandise Inventories

Merchandise inventories are valued at the lower of cost or market, as determined primarily by the retail method of accounting, and are stated using the last-in, first-out (LIFO) method for substantially all U.S. merchandise inventories. Merchandise inventories for all foreign operations are primarily valued by the retail method of accounting and are stated using the first-in, first-out (FIFO) method. We believe the LIFO method more fairly presents the results of operations by more closely matching current costs with current revenues. We record an adjustment each quarter, if necessary, for the expected annual effect of inflation, and these estimates are adjusted to actual results determined at fiscal year-end. At both September 2, 2007 and September 3, 2006 merchandise inventories valued at LIFO approximated FIFO after considering the lower of cost or market principle.

We provide for estimated inventory losses between physical inventory counts as a percentage of net sales. The provision is adjusted periodically to reflect results of the actual physical inventory count, which generally occur in the second and fourth fiscal quarters of the fiscal year.

Inventory cost, where appropriate, is reduced by estimates of vendor rebates when earned or as we progress toward earning those rebates, provided they are probable and reasonably estimable. Other consideration received from vendors is generally recorded as a reduction of merchandise costs upon completion of contractual milestones, terms of agreement, or other systematic and rational approaches.

Impairment of Long-Lived Assets and Warehouse Closing costs

We periodically evaluate our long-lived assets for indicators of impairment, such as a decision to relocate or close a warehouse location. Our judgments are based on existing market and operational conditions. Future events could cause us to conclude that impairment factors exist, requiring a downward adjustment of these assets to their then-current fair market value.

We provide estimates for warehouse closing costs for both leased and owned locations to be closed or relocated. A considerable amount of judgment is involved in determining any impairment or our net

 

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liability, particularly related to the estimated sales price of owned locations and the potential sublease income at leased locations. These estimates are based on real estate conditions in the markets and our experience in those markets. We make assumptions about the average period of time it would take to sublease the location and the amount of potential sublease income for each leased location. We reassess our liability each quarter and adjust our liability accordingly when our estimates change.

Insurance/Self Insurance Liabilities

We use a combination of insurance and self-insurance mechanisms, including a wholly-owned captive insurance entity and participation in a reinsurance pool, to provide for potential liabilities for workers’ compensation, general liability, property damage, director and officers’ liability, vehicle liability and employee health care benefits. Liabilities associated with the risks that we retain are not discounted and are estimated, in part, by considering historical claims experience and evaluations of outside experts, demographic factors, severity factors and other actuarial assumptions. The estimated accruals for these liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends.

Income Taxes

The determination of our provision for income taxes requires significant judgment, the use of estimates, and the interpretation and application of complex tax laws. Significant judgment is required in assessing, among other things, the timing and amounts of deductible and taxable items. We establish reserves when, despite our belief that our tax return positions are fully supportable, we determine that certain positions may be successfully challenged. When facts and circumstances change, we adjust these reserves through our provision for income taxes.

Recent Accounting Pronouncements

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (FIN 48), which clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in an income tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006 and we will adopt these new requirements as of the beginning of fiscal 2008. The estimated cumulative impact of adopting FIN 48 in fiscal 2008 is not expected to be material to our consolidated financial statements.

In September 2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 157, “Fair Value Measurements” (SFAS 157), which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair-value measurements required under other accounting pronouncements, but does not change existing guidance as to whether or not an instrument is carried at fair value. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Early adoption is permitted. We must adopt these new requirements no later than our first quarter of fiscal 2009.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment to FASB No. 115” (SFAS 159). Under SFAS 159, entities may elect to measure specified financial instruments and warranty and insurance contracts at fair value

 

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Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

 

on a contract-by-contract basis, with changes in fair value recognized in earnings each reporting period. The election, called the fair value option, will enable entities to achieve an offset accounting effect for changes in fair value of certain related assets and liabilities without having to apply complex hedge accounting provisions. SFAS 159 is effective as of the beginning of a company’s first fiscal year that begins after November 15, 2007. We must adopt these new requirements no later than our first quarter of fiscal 2009.

We are in the process of evaluating the impact that adoption of SFAS 157 and SFAS 159 will have on our future consolidated financial statements.

Item 7A—Quantitative and Qualitative Disclosures About Market Risk

We are exposed to financial market risk resulting from changes in interest and foreign currency rates. We do not engage in speculative or leveraged transactions, nor hold or issue financial instruments for trading purposes.

The nature and amount of our long and short-term debt can be expected to vary as a result of future business requirements, market conditions and other factors. As of September 2, 2007, our fixed-rate long-term debt included $67.6 million principal amount at maturity of 3.5% Zero Coupon Convertible Subordinated Notes carried at $47.8 million, $900.0 million of 5.3% Senior Notes carried at $897.8 million, $1.10 billion of 5.5% Senior Notes carried at $1.09 billion and additional notes and capital lease obligations totaling $127.9 million. Fluctuations in interest rates may affect the fair value of the fixed-rate debt.

We hold interest-bearing instruments that are classified as cash and cash equivalents and short-term investments. Our investment policy is to manage our cash and cash equivalents and short-term investment balances to preserve principal and liquidity, while seeking to enhance the return on our investment portfolio through the investment of available funds. We diversify our investment portfolio by investing in multiple types of investment-grade securities through a combination of internal and third-party investment management. Short-term investments generally have a maturity of three months to five years from the purchase date. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. As the majority of these instruments are of a short-term nature, if interest rates were to increase or decrease, there is no material risk of a material valuation adjustment related to these instruments. For those instruments that are classified as available for sale, the unrealized gains or losses related to fluctuations in interest rates are reflected within stockholder’s equity in accumulated other comprehensive income or loss. Based on our cash and cash equivalents and short-term investment balances at September 2, 2007, a 100 basis point increase or decrease in interest rates would result in an increase or decrease of approximately $15.2 million (pre-tax) to interest income on an annual basis.

Most transactions of our foreign subsidiaries are conducted in local currencies, limiting our exposure to changes in currency rates. We periodically enter into short-term forward foreign exchange contracts to hedge the impact of fluctuations in foreign currency rates on inventory purchases. The notional value of foreign exchange contracts outstanding at September 2, 2007 was $75.0 million.

 

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Item 8—Financial Statements and Supplementary Data

Financial statements of Costco are as follows:

 

     Page

Reports of Independent Registered Public Accounting Firm

   39

Consolidated Balance Sheets, as of September 2, 2007 and September 3, 2006

   41

Consolidated Statements of Income, for the 52 weeks ended September 2, 2007, the 53 weeks ended September 3, 2006 and the 52 weeks ended August 28, 2005

   42

Consolidated Statements of Stockholders’ Equity and Comprehensive Income, for the 52 weeks ended September 2, 2007, the 53 weeks ended September 3, 2006 and the 52 weeks ended August 28, 2005

   43

Consolidated Statements of Cash Flows, for the 52 weeks ended September 2, 2007, the 53 weeks ended September 3, 2006 and the 52 weeks ended August 28, 2005

   44

Notes to Consolidated Financial Statements

   45

Management’s Report on the Consolidated Financial Statements

Our management is responsible for the preparation, integrity and objectivity of the accompanying consolidated financial statements and the related financial information. The financial statements have been prepared in conformity with U.S. generally accepted accounting principles and necessarily include certain amounts that are based on estimates and informed judgments. Our management also prepared the related financial information included in this Annual Report on Form 10-K and is responsible for its accuracy and consistency with the financial statements.

The consolidated financial statements have been audited by KPMG LLP, an independent registered public accounting firm, who conducted their audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). The independent registered public accounting firm’s responsibility is to express an opinion as to the fairness with which such financial statements present our financial position, results of operations and cash flows in accordance with U.S. generally accepted accounting principles.

Item 9—Change in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A—Controls and Procedures

Disclosure Controls and Procedures

As of the end of the period covered by this Annual Report on Form 10-K we performed an evaluation under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities and Exchange Act of 1934 (the Exchange Act)). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this Annual Report, our disclosure controls and procedures are effective.

There has been no change in our internal control over financial reporting (as defined in Rules 13a-15(f) or 15d-15(f) of the Exchange Act) during our most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

The certifications required by Section 302 of the Sarbanes-Oxley Act of 2002 are filed as Exhibit 31.1 to this report.

 

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Item 9A—Controls and Procedures (Continued)

 

Management’s Annual Report on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Exchange Act. Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles and includes those policies and procedures that: (1) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect our transactions and the dispositions of our assets; (2) provide reasonable assurance that our transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with appropriate authorizations; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

Under the supervision and with the participation of our management, we assessed the effectiveness of our internal control over financial reporting as of September 2, 2007, using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control—Integrated Framework. Based on its assessment, management has concluded that our internal control over financial reporting was effective as of September 2, 2007.

KPMG LLP, an independent registered public accounting firm, has audited management’s assessment of the effectiveness of our internal control over financial reporting as of September 2, 2007, as stated in their audit report herein.

 

/S/ JAMES D. SINEGAL

 

/S/ RICHARD A. GALANTI

James D. Sinegal

President

Chief Executive Officer

 

Richard A. Galanti

Executive Vice President

Chief Financial Officer

Item 9B—Other Information

None.

 

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PART III

Item 10—Directors, Executive Officers and Corporate Governance

The information required by this Item concerning our directors and nominees for director is incorporated herein by reference to Costco’s proxy statement for its annual meeting of stockholders to be held on January 29, 2008 (“Proxy Statement”). The proxy statement will be filed with the Securities and Exchange Commission within 120 days of the end of our fiscal year.

The following is a list of the names, ages and positions of the executive officers of the registrant.

 

Name

  

Position With Company

   Executive
Officer
Since
   Age

James D. Sinegal

   President and Chief Executive Officer. Mr. Sinegal is a co-founder of the Company and has been a director since its inception.    1983    71

Jeffrey H. Brotman

   Chairman of the Board. Mr. Brotman is a co-founder of the Company and has been a director since its inception.    1983    65

Richard D. DiCerchio

   Sr. Executive Vice President, Chief Operating Officer, Global Operations, Distribution and Construction, Manufacturing and Ancillary Businesses. Mr. DiCerchio has been a Senior Executive Vice President of the Company since 1997. During fiscal 2004 Mr. DiCerchio assumed the responsibilities of Global Operations and Manufacturing and Ancillary Businesses and relinquished the role over Merchandising, which he had held since August 1994.    1986    64

Richard A. Galanti

   Executive Vice President and Chief Financial Officer.    1993    51

W. Craig Jelinek

   Executive Vice President, Chief Operating Officer, Merchandising. Mr. Jelinek has been Executive Vice President, Chief Operating Officer, Merchandising since February 2004. Prior to that date he was Executive Vice President, Chief Operating Officer—Northern Division.    1995    55

Paul G. Moulton

   Executive Vice President, Real Estate Development.    2001    56

Joseph P. Portera

   Executive Vice President, Chief Operating Officer— Eastern and Canadian Divisions.    1994    54

Douglas W. Schutt

   Executive Vice President, Chief Operating Officer— Northern and Midwest Division. Mr. Schutt has been Executive Vice President, Chief Operating Officer— Northern and Midwest Division, since February 2004. He was Senior Vice President, Electronic Commerce, Business Delivery, Costco Home, Special Order Kiosk and Roadshows from 2001 to February 2004.    2004    48

Thomas K. Walker

   Executive Vice President, Construction, Distribution and Traffic. Mr. Walker has been Executive Vice President, Construction, Distribution and Traffic since February 2004. He was Senior Vice President, Construction, Distribution and Traffic from August 1992 to February 2004.    2004    67

Dennis R. Zook

   Executive Vice President, Chief Operating Officer— Southwest and Mexico Divisions.    1993    58

 

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Item 10—Directors, Executive Officers and Corporate Governance (Continued)

 

The Company has adopted a code of ethics for senior financial officers pursuant to Section 406 of the Sarbanes-Oxley Act. Copies of the code are available free of charge by writing to Secretary, Costco Wholesale Corporation, 999 Lake Drive, Issaquah, WA 98027.

Item 11—Executive Compensation

The information required by this Item is incorporated herein by reference to the Proxy Statement. The Proxy Statement will be filed with the Securities and Exchange Commission within 120 days of the end of the Company’s fiscal year.

Item 12—Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information required by this Item is incorporated herein by reference to the Proxy Statement. The Proxy Statement will be filed with the Securities and Exchange Commission within 120 days of the end of the Company’s fiscal year.

Item 13—Certain Relationships and Related Transactions, and Director Independence

The information required by this Item is incorporated herein by reference to the Proxy Statement. The Proxy Statement will be filed with the Securities and Exchange Commission within 120 days of the end of the Company’s fiscal year.

Item 14—Principal Accounting Fees and Services

The information required by this Item is incorporated herein by reference to the Proxy Statement. The Proxy Statement will be filed with the Securities and Exchange Commission within 120 days of the end of the Company’s fiscal year.

PART IV

Item 15—Exhibits, Financial Statement Schedules

 

  (a) Documents filed as part of this report are as follows:

 

  1. Financial Statements:

See the listing of Financial Statements included as a part of this Form 10-K on Item 8 of Part II.

 

  2. Financial Statement Schedules—None.

 

  3. Exhibits:

The required exhibits are included at the end of the Form 10-K Annual Report and are described in the Exhibit Index immediately preceding the first exhibit.

 

  (b) Financial Statement Schedules—None.

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

October 25, 2007

 

COSTCO WHOLESALE CORPORATION

(Registrant)

By  

/s/ RICHARD A. GALANTI

 

 

Richard A. Galanti

Executive Vice President

and Chief Financial Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

By

  /s/ JAMES D. SINEGAL    

October 25, 2007

 

James D. Sinegal

President, Chief Executive Officer and Director

   

By

  /s/ JEFFREY H. BROTMAN    

October 25, 2007

 

Jeffrey H. Brotman

Chairman of the Board

   

By

  /s/ RICHARD D. DICERCHIO    

October 25, 2007

 

Richard D. DiCerchio

Sr. Executive Vice President, Chief Operating Officer Global Operations, Distribution and Construction, Manufacturing and Ancillary Businesses and
Director

   

By

  /s/ RICHARD A. GALANTI    

October 25, 2007

 

Richard A. Galanti

Executive Vice President, Chief Financial Officer and Director (Principal Financial Officer)

   

By

  /s/ DAVID S. PETTERSON    

October 25, 2007

 

David S. Petterson

Senior Vice President and Controller

(Principal Accounting Officer)

   

By

  /s/ DR. BENJAMIN S. CARSON, SR., M.D.    

October 25, 2007

 

Dr. Benjamin S. Carson, Sr., M.D.

Director

   

By

  /s/ SUSAN L. DECKER    

October 25, 2007

 

Susan L. Decker

Director

   

 

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By

  /s/ DANIEL J. EVANS    

October 25, 2007

 

Daniel J. Evans

Director

   

By

  /s/ WILLIAM H. GATES    

October 25, 2007

 

William H. Gates

Director

   

By

  /s/ HAMILTON E. JAMES    

October 25, 2007

 

Hamilton E. James

Director

   

By

  /s/ RICHARD M. LIBENSON    

October 25, 2007

 

Richard M. Libenson

Director

   

By

  /s/ JOHN W. MEISENBACH    

October 25, 2007

 

John W. Meisenbach

Director

   

By

  /s/ CHARLES T. MUNGER    

October 25, 2007

 

Charles T. Munger

Director

   

By

  /s/ JILL S. RUCKELSHAUS    

October 25, 2007

 

Jill S. Ruckelshaus

Director

   

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders

Costco Wholesale Corporation:

We have audited the accompanying consolidated balance sheets of Costco Wholesale Corporation and subsidiaries as of September 2, 2007 and September 3, 2006 and the related consolidated statements of income, stockholders’ equity and comprehensive income and cash flows for the 52-week period ended September 2, 2007, the 53-week period ended September 3, 2006, and the 52-week period ended August 28, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Costco Wholesale Corporation and subsidiaries as of September 2, 2007 and September 3, 2006, and the results of their operations and their cash flows for the 52-week period ended September 2, 2006, the 53-week period ended September 3, 2006, and the 52-week period ended August 28, 2005, in conformity with U.S. generally accepted accounting principles.

Effective August 29, 2005, the beginning of the Company’s fiscal year ended September 3, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” and Securities and Exchange Commission Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements.”

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of September 3, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated October 24, 2007 expressed an unqualified opinion on internal control over financial reporting.

/s/  KPMG LLP

Seattle, Washington

October 24, 2007

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders

Costco Wholesale Corporation:

We have audited Costco Wholesale Corporation’s (the Company) internal control over financial reporting as of September 2, 2007, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying management’s annual report on internal control over financial reporting included in Item 9A. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 2, 2007, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of September 2, 2007 and September 3, 2006, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for the 52-week period ended September 2, 2007, the 53–week period ended September 3, 2006, and the 52-week period ended August 28, 2005, and our report dated October 24, 2007 expressed an unqualified opinion on those consolidated financial statements.

/s/ KPMG LLP

Seattle, Washington

October 24, 2007

 

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COSTCO WHOLESALE CORPORATION

CONSOLIDATED BALANCE SHEETS

(amounts in thousands, except par value)

 

     September 2,
2007
    September 3,
2006
 
ASSETS     

CURRENT ASSETS

    

Cash and cash equivalents

   $ 2,779,733     $ 1,510,939  

Short-term investments

     575,787       1,322,181  

Receivables, net

     762,017       565,373  

Merchandise inventories

     4,879,465       4,561,232  

Deferred income taxes and other current assets

     327,151       272,357  
                

Total current assets

     9,324,153       8,232,082  
                

PROPERTY AND EQUIPMENT

    

Land

     3,009,514       2,747,396  

Buildings, leasehold and land improvements

     7,035,672       6,241,357  

Equipment and fixtures

     2,747,243       2,405,229  

Construction in progress

     276,087       248,454  
                
     13,068,516       11,642,436  

Less accumulated depreciation and amortization

     (3,548,736 )     (3,078,141 )
                

Net property and equipment

     9,519,780       8,564,295  
                

OTHER ASSETS

     762,653       698,693  
                
   $ 19,606,586     $ 17,495,070  
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

CURRENT LIABILITIES

    

Short-term borrowings

   $ 53,832     $ 41,385  

Accounts payable

     5,124,990       4,581,395  

Accrued salaries and benefits

     1,226,666       1,080,382  

Accrued sales and other taxes

     267,920       324,274  

Deferred membership fees

     692,176       583,946  

Current portion of long-term debt

     59,905       308,523  

Other current liabilities

     1,156,264       899,286  
                

Total current liabilities

     8,581,753       7,819,191  

LONG-TERM DEBT, excluding current portion

     2,107,978       215,369  

DEFERRED INCOME TAXES AND OTHER LIABILITIES

     224,197       253,713  
                

Total liabilities

     10,913,928       8,288,273  

COMMITMENTS AND CONTINGENCIES

    

MINORITY INTEREST

     69,317       63,358  

STOCKHOLDERS’ EQUITY

    

Preferred stock $.005 par value; 100,000,000 shares authorized; no shares issued and outstanding

            

Common stock $.005 par value; 900,000,000 shares authorized; 437,013,000 and 462,279,000 shares issued and outstanding

     2,185       2,312  

Additional paid-in capital

     3,118,224       2,822,652  

Accumulated other comprehensive income

     370,589       277,263  

Retained earnings

     5,132,343       6,041,212  
                

Total stockholders’ equity

     8,623,341       9,143,439  
                
   $ 19,606,586     $ 17,495,070  
                

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

COSTCO WHOLESALE CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(amounts in thousands, except per share data)

 

     52 weeks ended
September 2,
2007
    53 weeks ended
September 3,
2006
   

52 weeks ended
August 28,

2005

 

REVENUE

      

Net sales

   $ 63,087,601     $ 58,963,180     $ 51,879,070  

Membership fees

     1,312,554       1,188,047       1,073,156  
                        

Total revenue

     64,400,155       60,151,227       52,952,226  

OPERATING EXPENSES

      

Merchandise costs

     56,449,702       52,745,497       46,346,961  

Selling, general and administrative

     6,273,096       5,732,141       5,061,339  

Preopening expenses

     55,163       42,504       53,230  

Provision for impaired assets and closing costs, net

     13,608       5,453       16,393  
                        

Operating income

     1,608,586       1,625,632       1,474,303  

OTHER INCOME (EXPENSE)

      

Interest expense

     (64,079 )     (12,570 )     (34,437 )

Interest income and other

     165,484       138,355       109,096  
                        

INCOME BEFORE INCOME TAXES

     1,709,991       1,751,417       1,548,962  

Provision for income taxes

     627,219       648,202       485,870  
                        

NET INCOME

   $ 1,082,772     $ 1,103,215     $ 1,063,092  
                        

NET INCOME PER COMMON SHARE:

      

Basic

   $ 2.42     $ 2.35     $ 2.24  
                        

Diluted

   $ 2.37     $ 2.30     $ 2.18  
                        

Shares used in calculation (000’s)

      

Basic

     447,659       469,718       473,945  

Diluted

     457,641       480,341       492,035  

Dividends per share

   $ 0.55     $ 0.49     $ 0.43  

The accompanying notes are an integral part of these consolidated financial statements.

 

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COSTCO WHOLESALE CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

AND COMPREHENSIVE INCOME

(in thousands)

 

    Common Stock    

Additional
Paid-In
Capital

   

Accumulated
Other
Comprehensive
Income

 

Retained
Earnings

   

Total

 
    Shares     Amount          

BALANCE AT AUGUST 29, 2004

  462,637     $ 2,313     $ 1,466,366     $ 16,144   $ 6,139,987     $ 7,624,810  

Comprehensive Income:

           

Net Income

                        1,063,092       1,063,092  

Foreign currency translation adjustment and other

                    141,895           141,895  
                 

Comprehensive income

              1,204,987  

Stock options exercised, including income tax benefits and other

  9,138       46       323,545                 323,591  

Conversion of convertible notes

  9,910       49       277,554                 277,603  

Stock repurchase

  (9,205 )     (46 )     (38,848 )         (374,358 )     (413,252 )

Stock-based compensation

              67,937                 67,937  

Cash dividends

                        (204,567 )     (204,567 )
                                           

BALANCE AT AUGUST 28, 2005

  472,480       2,362       2,096,554       158,039     6,624,154       8,881,109  

Cumulative effect of adjustments resulting from the adoption of SAB No. 108, net of tax

              147,637           (139,481 )     8,156  
                                           

Adjusted balance at August 28, 2005

  472,480       2,362       2,244,191       158,039     6,484,673       8,889,265  

Comprehensive Income:

           

Net Income

                        1,103,215       1,103,215  

Foreign currency translation adjustment and other

                    119,224           119,224  
                 

Comprehensive income

              1,222,439  

Stock options exercised, including income tax benefits and other

  11,712       59       427,291                 427,350  

Conversion of convertible notes

  6,505       33       188,902                 188,935  

Stock repurchase

  (28,418 )     (142 )     (145,129 )         (1,316,465 )     (1,461,736 )

Stock-based compensation

              107,397                 107,397  

Cash dividends

                        (230,211 )     (230,211 )
                                           

BALANCE AT SEPTEMBER 3, 2006

  462,279       2,312       2,822,652       277,263     6,041,212       9,143,439  

Comprehensive Income:

           

Net Income

                        1,082,772       1,082,772  

Foreign currency translation adjustment and other

                    93,326           93,326  
                 

Comprehensive income

              1,176,098  

Stock options exercised, including income tax benefits, vesting of restricted stock units and other

  9,735       48       351,756                 351,804  

Conversion of convertible notes

  1,389       7       42,323                 42,330  

Stock repurchase

  (36,390 )     (182 )     (233,089 )         (1,745,899 )     (1,979,170 )

Stock-based compensation

              134,582                 134,582  

Cash dividends

                        (245,742 )     (245,742 )
                                           

BALANCE AT SEPTEMBER 2, 2007

  437,013     $ 2,185     $ 3,118,224     $ 370,589   $ 5,132,343     $ 8,623,341  
                                           

The accompanying notes are an integral part of these consolidated financial statements.

 

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COSTCO WHOLESALE CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(amounts in thousands)

 

     52 Weeks ended
September 2,
2007
    53 Weeks ended
September 3,
2006
   

52 Weeks ended
August 28,

2005

 

CASH FLOWS FROM OPERATING ACTIVITIES

      

Net income

   $ 1,082,772     $ 1,103,215     $ 1,063,092  

Adjustments to reconcile net income to net cash provided by operating activities:

      

Depreciation and amortization

     566,385       515,285       481,838  

Stock-based compensation

     134,582       107,397       67,937  

Undistributed equity earnings in joint ventures

     (34,080 )     (28,180 )     (26,459 )

Net (gain) / loss on sale of property and equipment and other

     (105 )     5,867       5,139  

Accretion of discount on long-term debt

     3,074       4,828       11,855  

Excess tax benefit on share based awards

     (25,141 )     (31,296 )      

Other non-cash items, net

     (5,055 )     (5,888 )     (11,186 )

Change in deferred income taxes

     (92,739 )     (38,311 )     (64,690 )

Provision for impaired assets

                 3,893  

Change in receivables, other current assets, deferred income, accrued and other current liabilities

     284,306       414,704       78,118  

Increase in merchandise inventories

     (272,513 )     (499,194 )     (315,793 )

Increase in accounts payable

     434,918       282,797       479,067  
                        

Total adjustments

     993,632       728,009       709,719  
                        

Net cash provided by operating activities

     2,076,404       1,831,224       1,772,811  
                        

CASH FLOWS FROM INVESTING ACTIVITIES

      

Additions to property and equipment, net of $41,519, $3,934 and $(3,150) of accrued capital expenditures for fiscal 2007, 2006 and 2005, respectively

     (1,385,699 )     (1,216,501 )     (992,281 )

Proceeds from the sale of property and equipment

     14,054       15,740       19,432  

Investment in unconsolidated joint venture

           (15,000 )     (15,000 )

Purchase of minority interests

                 (3,961 )

Purchases of short-term investments

     (1,160,663 )     (2,598,355 )     (3,741,429 )

Maturities of short-term investments

     1,417,731       2,424,503       2,401,248  

Sales of short-term investments

     496,192       263,288       267,640  

Change in other assets and other, net

     (36,925 )     (31,169 )     15,988  
                        

Net cash used in investing activities

     (655,310 )     (1,157,494 )     (2,048,363 )
                        

CASH FLOWS FROM FINANCING ACTIVITIES

      

Change in bank checks outstanding

     23,375       33,559       85,829  

Proceeds from/(repayments of) short-term borrowings, net

     9,961       (12,929 )     33,433  

Proceeds from issuance of long-term debt, net

     1,994,187       18,375       5,660  

Repayments of long-term debt

     (307,894 )     (7,586 )     (303,877 )

Cash dividend payments

     (245,742 )     (230,211 )     (204,567 )

Change in minority interests

     5,959       4,744       (130 )

Excess tax benefit on share based awards

     25,141       31,296        

Exercise of stock options

     307,988       372,336       278,253  

Repurchases of common stock

     (1,977,607 )     (1,442,811 )     (413,252 )
                        

Net cash used in financing activities

     (164,632 )     (1,233,227 )     (518,651 )
                        

EFFECT OF EXCHANGE RATE CHANGES ON CASH

     12,332       7,851       33,653  
                        

Net increase/(decrease) in cash and cash equivalents

     1,268,794       (551,646 )     (760,550 )

CASH AND CASH EQUIVALENTS BEGINNING OF YEAR

     1,510,939       2,062,585       2,823,135  
                        

CASH AND CASH EQUIVALENTS END OF YEAR

   $ 2,779,733     $ 1,510,939     $ 2,062,585  
                        

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:

      

Cash paid during the year for:

      

Interest (net of $11,423, $12,681 and $7,226 interest capitalized for fiscal 2007, 2006 and 2005, respectively)

   $ 9,369     $ 4,147     $ 21,374  

Income taxes

   $ 786,283     $ 546,205     $ 804,957  

SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES:

      

Common stock issued upon conversion of 3.5% Zero Coupon Convertible Subordinated Notes

   $ 42,697     $ 190,871     $ 280,816  

The accompanying notes are an integral part of these consolidated financial statements.

 

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COSTCO WHOLESALE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data)

Note 1—Summary of Significant Accounting Policies

Basis of Presentation

The consolidated financial statements include the accounts of Costco Wholesale Corporation, a Washington corporation, and its subsidiaries (“Costco” or the “Company”). All material inter-company transactions between the Company and its subsidiaries have been eliminated in consolidation.

Costco operates membership warehouses that offer low prices on a limited selection of nationally branded and selected private label products in a wide range of merchandise categories in no-frills, self-service warehouse facilities. At September 2, 2007, Costco operated 488 warehouses: 379 in the United States and 4 in Puerto Rico; 71 in Canada; 19 in the United Kingdom; 6 in Japan; 5 in Korea; and 4 in Taiwan. The Company’s 50%-owned joint venture in Mexico operates an additional 30 warehouses.

The Company’s investments in the Costco Mexico joint venture and in other unconsolidated joint ventures that are less than majority owned are accounted for under the equity method. The investment in Costco Mexico is included in other assets and was $302,550 at September 2, 2007 and $270,304 at September 3, 2006. The equity in earnings of Costco Mexico is included in interest income and other in the accompanying consolidated statements of income, and for fiscal 2007, 2006 and 2005, was $33,499, $26,646 and $24,949, respectively. The amount of retained earnings that represents undistributed earnings of Costco Mexico was $193,176 and $159,677 at September 2, 2007 and September 3, 2006, respectively. The investments and equity in earnings of other unconsolidated joint ventures are not material.

The Company, in accordance with Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (SAB 108), adjusted its beginning retained earnings for fiscal 2006 in the accompanying consolidated financial statements. See Note 11 for additional information on the adoption SAB 108.

Fiscal Year End

Costco operates on a 52/53-week fiscal year basis with the fiscal year ending on the Sunday closest to August 31. The fiscal year ended September 2, 2007 included 52 weeks. The fiscal year ended September 3, 2006 included 53 weeks, with the 53rd week falling in the fiscal fourth quarter. The fiscal year ended August 28, 2005 included 52 weeks.

Use of Estimates

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Reclassifications

Certain reclassifications have been made to prior fiscal year amounts or balances to conform to the presentation adopted in the current fiscal year.

Cash and Cash Equivalents

The Company considers as cash and cash equivalents all highly liquid investments with a maturity of three months or less at the date of purchase and proceeds due from credit and debit card transactions

 

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COSTCO WHOLESALE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 1—Summary of Significant Accounting Policies (Continued)

 

with settlement terms of less than five days. Of the total cash and cash equivalents of $2,779,733 at September 2, 2007 and $1,510,939 at September 3, 2006, credit and debit card receivables were $655,205 and $593,645, respectively.

Short-term Investments

In general, short-term investments have a maturity of three months to five years at the date of purchase. Investments with maturities beyond five years may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. Short-term investments classified as available-for-sale are recorded at market value using the specific identification method with the unrealized gains and losses reflected in accumulated other comprehensive income until realized. The estimate of fair value is based on publicly available market information or other estimates determined by management. Realized gains and losses from the sale of available-for-sale securities, if any, are determined on a specific identification basis.

Receivables, net

Receivables consist primarily of vendor rebates and promotional allowances, receivables from government tax authorities, reinsurance receivables held by the Company’s wholly-owned captive insurance subsidiary and other miscellaneous amounts due to the Company. Vendor receivable balances are presented on a gross basis separate from any related payable due to that vendor. However, in certain circumstances, these receivables may be settled against the related payable to that vendor. Amounts are recorded net of an allowance for doubtful accounts of $3,459 at September 2, 2007 and $2,423 at September 3, 2006. Management determines the allowance for doubtful accounts based on historical experience and application of the specific identification method.

Vendor Rebates and Allowances

Periodic payments from vendors in the form of volume rebates or other purchase discounts that are evidenced by signed agreements are reflected in the carrying value of the inventory when earned or as the Company progresses towards earning the rebate or discount and as a component of merchandise costs as the merchandise is sold. Other consideration received from vendors is generally recorded as a reduction of merchandise costs upon completion of contractual milestones, terms of the related agreement, or by other systematic and rational approach.

Merchandise Inventories

Merchandise inventories are valued at the lower of cost or market, as determined primarily by the retail method of accounting, and are stated using the last-in, first-out (LIFO) method for substantially all U.S. merchandise inventories. Merchandise inventories for all foreign operations are primarily valued by the retail method of accounting and are stated using the first-in, first-out (FIFO) method. The Company believes the LIFO method more fairly presents the results of operations by more closely matching current costs with current revenues. The Company records an adjustment each quarter, if necessary, for the expected annual effect of inflation, and these estimates are adjusted to actual results determined at year-end. At both September 2, 2007 and September 3, 2006, merchandise inventories valued at LIFO approximated FIFO after considering the lower of cost or market principle.

 

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COSTCO WHOLESALE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 1—Summary of Significant Accounting Policies (Continued)

 

     September 2,
2007
   September 3,
2006

Merchandise inventories consist of:

     

United States (primarily LIFO)

   $ 3,799,999    $ 3,613,412

Foreign (FIFO)

     1,079,466      947,820
             

Total

   $ 4,879,465    $ 4,561,232
             

The Company provides for estimated inventory losses between physical inventory counts as a percentage of net sales, using estimates based on the Company’s experience. The provision is adjusted periodically to reflect the results of the actual physical inventory counts, which generally occur in the second and fourth fiscal quarters of the fiscal year. Inventory cost, where appropriate, is reduced by estimates of vendor rebates when earned or as the Company progresses towards earning those rebates, provided they are probable and reasonably estimable.

Property and Equipment

Property and equipment are stated at cost. Depreciation and amortization expenses are computed using the straight-line method. Estimated useful lives by major asset category are as follows:

 

     Years

Buildings

   5 - 50

Equipment and fixtures

   3 - 10

Leasehold improvements

   Shorter of useful life or
lease term

Land improvements

   15

Software acquisition and development

   3 - 6

Interest costs incurred on property during the construction period are capitalized. The amount of interest costs capitalized was $11,423 in fiscal 2007, $12,681 in fiscal 2006, and $7,226 in fiscal 2005.

Impairment of Long-Lived Assets

The Company periodically evaluates long-lived assets for impairment when management makes the decision to relocate or close a warehouse or when events or changes in circumstances occur that may indicate the carrying amount of the asset group may not be fully recoverable. The Company evaluates whether the carrying value of the asset group is recoverable by comparing the estimated future undiscounted cash flows generated from the use of the asset group and its eventual disposition with the asset group’s reported net carrying value. The Company recorded a pre-tax, non-cash charge of $3,893 in fiscal 2005, reflecting its estimate of impairment relating to real property. The charge reflects the difference between the carrying value and fair value, which was based on estimated market valuations for those asset groups whose carrying value is not currently anticipated to be recoverable through future cash flows.

 

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COSTCO WHOLESALE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 1—Summary of Significant Accounting Policies (Continued)

 

Closing Costs

Warehouse closing costs incurred relate principally to the Company’s relocation of certain warehouses that were not otherwise impaired to larger and better-located facilities. The provision for fiscal 2007 included charges of $15,887 for warehouse closing expenses, primarily related to accelerated depreciation on buildings to be demolished or sold and $2,279 for net gains related to the sale of real property. The fiscal 2006 provision included charges of $3,762 for warehouse closing expenses and net losses of $1,691 related to the sale of real property. The fiscal 2005 provision included charges of $11,619 for warehouse closing expenses, primarily related to lease obligations and accelerated depreciation and $881 for net losses on the sale of real property. As of September 2, 2007, the Company’s reserve for warehouse closing costs was $6,823 of which $6,086 related to future lease obligations. This compares to a reserve for warehouse closing costs of $7,041 at September 3, 2006, of which $5,950 related to future lease obligations.

Goodwill

Goodwill resulting from certain business combinations is included in other assets, and totaled $75,707 at September 2, 2007 and $72,953 at September 3, 2006. The Company reviews goodwill for impairment in the fourth quarter of each fiscal year, or more frequently if circumstances dictate. No impairment of goodwill has been incurred to date.

Accounts Payable

The Company’s banking system provides for the daily replenishment of major bank accounts as checks are presented. Accordingly, included in accounts payable at September 2, 2007 and September 3, 2006 are $591,936 and $564,754, respectively, representing the excess of outstanding checks over cash on deposit at the banks on which the checks were drawn.

Insurance/Self Insurance Liabilities

The Company uses a combination of insurance and self-insurance mechanisms, including a wholly-owned captive insurance entity and participation in a reinsurance pool, to provide for potential liabilities for workers’ compensation, general liability, property damage, director and officers’ liability, vehicle liability and employee health care benefits. Liabilities associated with the risks that are retained by the Company are not discounted and are estimated, in part, by considering historical claims experience and evaluations of outside expertise, demographic factors, severity factors and other actuarial assumptions. The estimated accruals for these liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends. As of the end of fiscal 2007 and 2006, these liabilities of $488,734 and $491,037, respectively, were included in accrued salaries and benefits, other current liabilities and accounts payable on the consolidated balance sheets.

The Company’s wholly-owned captive insurance subsidiary participates in a reinsurance pool. The member agreements and practices of the reinsurance pool limit any participating members’ individual risk. Reinsurance revenues earned of $50,897, $67,589 and $61,697 during fiscal 2007, 2006 and 2005, respectively, were primarily related to premiums received from the reinsurance pool. Reinsurance costs of $52,179, $65,760 and $65,830 during fiscal 2007, 2006 and 2005, respectively, primarily related to premiums paid to the reinsurance pool. Both revenues and costs are presented net in selling, general and administrative expenses in the consolidated statements of income.

 

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COSTCO WHOLESALE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 1—Summary of Significant Accounting Policies (Continued)

 

Derivatives

The Company has limited involvement with derivative financial instruments and uses them only to manage well-defined interest rate and foreign exchange risks. Forward foreign exchange contracts are used to hedge the impact of fluctuations of foreign exchange on inventory purchases and typically have very short terms. These forward contracts do not qualify for derivative hedge accounting. The aggregate notional amounts, which approximate the fair value of foreign exchange contracts outstanding at September 2, 2007 and September 3, 2006, were $74,950 and $63,487, respectively. The majority of the forward foreign exchange contracts were entered into by the Company’s wholly-owned United Kingdom subsidiary primarily to hedge U.S. dollar merchandise inventory purchases.

Effective March 25, 2002, the Company entered into “fixed-to-floating” interest rate swaps associated with its $300,000 5.5% Senior Notes which matured and were retired in March 2007. The swaps were designated and qualified as fair value hedges of the debt. As the terms of the swaps matched those of the underlying hedged debt, changes in the fair value of the swaps were offset by corresponding changes in the carrying amount of the hedged debt and resulted in no net earnings impact. At September 3, 2006, the aggregate value of the swaps was $1,243 and was included in deferred income taxes and other current assets on the Company’s consolidated balance sheets. In March 2007, upon maturity of the debt and expiration of the swap agreements, the aggregate fair value of the swaps was zero.

The Company is exposed to market risk for changes in utility commodity pricing, which it partially mitigates through the use of firm-price contracts with counterparties for approximately 23% of its locations. The effects of these arrangements were not significant for any period presented.

Equity Investments in Subsidiary and Joint Ventures

During 2006 and 2005, the Company contributed an additional $15,000 to its investment in Costco Mexico (a 50%-owned joint venture), which did not impact its percentage ownership of this entity, as the joint venture partner contributed a like amount. The Company did not contribute additional capital in 2007.

Foreign Currency Translation

The functional currencies of the Company’s international subsidiaries are the local currency of the country in which the subsidiary is located. Assets and liabilities recorded in foreign currencies, as well as the Company’s investment in the Costco Mexico joint venture, are translated at the exchange rate on the balance sheet date. Translation adjustments resulting from this process are charged or credited to accumulated other comprehensive income. Revenue and expenses of the Company’s consolidated foreign operations are translated at average rates of exchange prevailing during the year. Gains and losses on foreign currency transactions are included in interest income and other and were not significant in fiscal 2007, 2006, or 2005.

Revenue Recognition

The Company generally recognize sales, net of estimated returns, at the time the member takes possession of merchandise or receives services. When the Company collects payments from customers prior to the transfer of ownership of merchandise or the performance of services, the amounts received

 

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COSTCO WHOLESALE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 1—Summary of Significant Accounting Policies (Continued)

 

are generally recorded as deferred revenue on the consolidated balance sheets until the sale or service is completed. The Company provides for estimated sales returns based on historical merchandise returns levels.

During 2007, in connection with changes to its consumer electronic returns policy, the Company developed more detailed operational data regarding member return patterns. The data indicated a longer timeframe over which returns are received than previously used to estimate the sales return reserve. Accordingly, during fiscal 2007 the Company increased the reserve balance and recorded an adjustment to sales of $452,553 and a pretax charge to income of $95,263 for the related gross margin and disposition costs.

The Company evaluates the criteria of the Financial Accounting Standards Board (FASB) Emerging Issues Task Force (EITF) 99-19, “Reporting Revenue Gross as a Principal Versus Net as an Agent,” in determining whether it is appropriate to record the gross amount of merchandise sales and related costs or the net amount earned as commissions. Generally, when Costco is the primary obligor, is subject to inventory risk, has latitude in establishing prices and selecting suppliers, can influence product or service specifications, or has several but not all of these indicators, revenue is recorded on a gross basis. If the Company is not the primary obligor and does not possess other indicators of gross reporting as noted above, it records the net amounts as commissions earned, which is reflected in net sales.

Amounts collected from members, which under common trade practices are referred to as sales taxes, are recorded on a net basis.

Membership fee revenue represents annual membership fees paid by substantially all of the Company’s members. The Company accounts for membership fee revenue on a deferred basis, whereby membership fee revenue is recognized ratably over one-year. In the fourth quarter of fiscal 2007, the Company performed a detailed analysis of the timing of recognition of membership fees based on each member’s specific renewal date, as this methodology represented an improvement over the historical method, which was based on the period in which the fee was collected. This review resulted in a $56,183 reduction to membership fee revenue and a corresponding increase to deferred membership fees on the Company’s consolidated balance sheet. This adjustment included both a change in method of applying an accounting principle to a preferable method and a correction for cumulative timing errors. The adjustment for the change in method and for the correction was recorded in full in the fiscal 2007 consolidated statement of income as the Company concluded the impact to the current and historical financial statements was not material. Membership fees received from members for fiscal years 2007, 2006 and 2005 were $1,415,134, $1,264,929 and $1,113,948, respectively.

 

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COSTCO WHOLESALE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 1—Summary of Significant Accounting Policies (Continued)

 

The Company’s Executive members qualify for a 2% reward (which can be redeemed at Costco warehouses), up to a maximum of $500 per year, on all qualified purchases made at Costco. The Company accounts for this 2% reward as a reduction in sales, with the related liability being classified within other current liabilities. The sales reduction and corresponding liability are computed after giving effect to the estimated impact of non-redemptions based on historical data. The reduction in sales for the fiscal years ended September 2, 2007, September 3, 2006, and August 28, 2005, and the related liability as of those dates were as follows:

 

     Fiscal 2007    Fiscal 2006    Fiscal 2005

Two-percent reward sales reduction

   $ 487,877    $ 418,466    $ 319,336

Two-percent unredeemed reward liability

   $ 363,399    $ 299,519    $ 229,574

Merchandise Costs

Merchandise costs consist of the purchase price of inventory sold, inbound shipping charges and all costs related to the Company’s depot operations, including freight from depots to selling warehouses and are reduced by vender consideration received. Merchandise costs also include salaries, benefits, depreciation on production equipment, and other related expenses incurred by the Company’s cross-docking depot facilities and in certain fresh foods and ancillary departments.

Selling, General and Administrative Expenses

Selling, general and administrative expenses consist primarily of salaries, benefits and workers’ compensation costs for warehouse employees, other than depots, fresh foods and certain ancillary businesses, as well as all regional and home office employees, including buying personnel. Selling, general and administrative expenses also include utilities, bank charges and substantially all building and equipment depreciation, as well as other operating costs incurred to support warehouse operations.

Marketing and Promotional Expenses

Costco’s policy is generally to limit marketing and promotional expenses to new warehouse openings, occasional direct mail marketing to prospective new members and direct mail marketing programs to existing members promoting selected merchandise. Marketing and promotional costs are expensed as incurred and are included in selling, general and administrative and preopening expenses in the accompanying consolidated statements of income.

Preopening Expenses

Preopening expenses related to new warehouses, major remodels and expansions, new regional offices and other startup operations are expensed as incurred.

Stock-Based Compensation

At the beginning of fiscal 2003, the Company adopted, on a prospective basis, Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” (SFAS 123) and all employee stock option grants made since the beginning of fiscal 2003 have been or will be

 

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COSTCO WHOLESALE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 1—Summary of Significant Accounting Policies (Continued)

 

expensed ratably over the related vesting period based on the fair value at the date the options were granted (however, see “Review of Stock Option Grant Practices” in Note 11, for a discussion of a special committee review of historical grant practices).

The Company adopted SFAS 123R, “Share-Based Payment (as amended)” (SFAS 123R) at the beginning of fiscal 2006, which requires companies to measure all employee stock-based compensation awards using a fair value method and record such expense in its consolidated financial statements. Had compensation costs for the Company’s stock-based compensation been determined for awards made prior to fiscal 2003 under SFAS 123R, the Company’s net income and net income per share would have been adjusted to the proforma amounts indicated below:

 

     Fiscal 2005  

Net income, as reported

   $ 1,063,092  

Add: Stock-based compensation expense included in reported net income, net of related tax effects

     43,344  

Deduct: Total stock-based compensation expense determined under fair value-based methods for all awards, net of related tax effects

     (63,012 )
        

Proforma net income

   $ 1,043,424  
        

Net Income per share:

  

Basic—as reported

   $ 2.24  
        

Basic—pro-forma

   $ 2.20  
        

Diluted—as reported

   $ 2.18  
        

Diluted—pro-forma

   $ 2.12  
        

Fair Value of Financial Instruments

The carrying value of the Company’s financial instruments, including cash and cash equivalents, receivables and accounts payable approximate fair value due to their short-term nature or variable interest rates. Short-term investments classified as available-for-sale are recorded at market value with unrealized gains or losses reflected in accumulated other comprehensive income. Short-term investments designated as “hold-to-maturity” securities are recorded at cost which approximated market value at September 2, 2007 and September 3, 2006. The fair value of fixed rate debt at September 2, 2007 and September 3, 2006 was $2,249,977 and $574,426, respectively. The carrying value of fixed rate debt at September 2, 2007 and September 3, 2006 was $2,167,883 and $523,892, respectively.

Interest Income and Other

Interest income and other includes:

 

     Fiscal 2007    Fiscal 2006     Fiscal 2005

Interest income

   $ 128,413    $ 113,712     $ 81,915

Earnings of affiliates

     35,622      28,180       26,459

Minority Interest / Other

     1,449      (3,537 )     722
                     

Total

   $ 165,484    $ 138,355     $ 109,096
                     

 

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COSTCO WHOLESALE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 1—Summary of Significant Accounting Policies (Continued)

 

Income Taxes

The Company accounts for income taxes using the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributed to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax credits and loss carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences and carry-forwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established when necessary to reduce deferred tax assets to amounts expected to be realized.

Significant judgment is required in determining income tax provisions and evaluating tax positions. The Company establishes reserves for income taxes when, despite the belief that its tax positions are fully supportable, there remain certain positions that are not probable of being sustained. The consolidated tax provision and related accruals include the impact of such reasonably estimable losses and related interest and penalties as deemed appropriate. To the extent that the probable tax outcome of these matters changes, such changes in estimate will impact the income tax provision in the period in which such determination is made.

Net Income per Common Share

The computation of basic net income per share is based on the weighted average number of shares that were outstanding during the period. The computation of diluted earnings per share is based on the weighted average number of shares used in the basic net income per share calculation plus the number of common shares that would be issued assuming exercise of all potentially dilutive common shares outstanding using the treasury stock method for shares subject to stock options and restricted stock units and the “if converted” method for the convertible note securities.

Stock Repurchase Programs

Share repurchases are not displayed separately as treasury stock on the consolidated balance sheets or consolidated statements of stockholders’ equity in accordance with the Washington Business Corporation Act, which requires retirement of repurchased shares. The par value of repurchased shares is deducted from common stock and the excess repurchase price over par value is deducted from additional paid-in capital and retained earnings. See Note 5 for additional information.

Recent Accounting Pronouncements

In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (FIN 48), which clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in an income tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, account-

 

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COSTCO WHOLESALE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 1—Summary of Significant Accounting Policies (Continued)

 

ing in interim periods, disclosure and transition. FIN 48 is effective for financial statements issued for fiscal years beginning after December 15, 2006, and the Company will adopt these new requirements as of the beginning of fiscal 2008. The estimated cumulative impact of adopting FIN 48 in fiscal 2008 is not expected to be material to the Company’s consolidated financial statements.

In September 2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 157, “Fair Value Measurements” (SFAS 157), which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair-value measurements required under other accounting pronouncements, but does not change existing guidance as to whether or not an instrument is carried at fair value. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Early adoption is permitted. The Company must adopt these new requirements no later than its first quarter of fiscal 2009.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment to FASB No. 115” (SFAS 159). Under SFAS 159, entities may elect to measure specified financial instruments and warranty and insurance contracts at fair value on a contract-by-contract basis, with changes in fair value recognized in earnings each reporting period. The election, called the fair value option, will enable entities to achieve an offset accounting effect for changes in fair value of certain related assets and liabilities without having to apply complex hedge accounting provisions. SFAS 159 is effective as of the beginning of a company’s first fiscal year that begins after November 15, 2007. The Company must adopt these new requirements no later than its first quarter of fiscal 2009.

The Company is in the process of evaluating the impact that adoption of SFAS 157 and SFAS 159 will have on its future consolidated financial statements.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

 

Note 2—Short-term Investments

Short-term investments, which consist entirely of debt securities, at September 2, 2007 and September 3, 2006, were as follows:

 

     Fiscal 2007
     Cost Basis    Unrealized
Gains
   Unrealized
Losses
    Recorded
Basis

Available-for-sale securities

          

Money market mutual funds

   $ 5,931    $ 7    $     $ 5,938

U.S. government and agency securities

     268,886      552      (954 )     268,484

Corporate notes and bonds

     150,811      303      (1,070 )     150,044

Asset and mortgage backed securities

     72,919      209      (370 )     72,758
                            

Total available-for-sale securities

     498,547      1,071      (2,394 )     497,224

Held-to-maturity

          

Certificates of deposit

     78,247                 78,247

Money market mutual funds

     316                 316
                            

Total held-to-maturity securities

     78,563                 78,563
                            

Total short-term investments

   $ 577,110    $ 1,071    $ (2,394 )   $ 575,787
                            
     Fiscal 2006
     Cost Basis    Unrealized
Gains
   Unrealized
Losses
    Recorded
Basis

Available-for-sale securities

          

Money market mutual funds

   $ 38,366    $    $     $ 38,366

U.S. government and agency securities

     651,984      396      (5,630 )     646,750

Corporate notes and bonds

     505,739      605      (2,785 )     503,559

Asset and mortgage backed securities

     71,801      121      (484 )     71,438
                            

Total available-for-sale securities

     1,267,890      1,122      (8,899 )     1,260,113

Held-to-maturity

          

Certificates of deposit

     55,185                 55,185

Money market mutual funds

     6,883                 6,883
                            

Total held-to-maturity securities

     62,068                 62,068
                            

Total short-term investments

   $ 1,329,958    $ 1,122    $ (8,899 )   $ 1,322,181
                            

For available-for-sale securities, proceeds from sales were $496,192, $263,288, and $267,640 in fiscal years 2007, 2006 and 2005, respectively. Gross realized gains from sales were $933, $170 and $90 in fiscal years 2007, 2006 and 2005, respectively, and gross realized losses from sales were $1,285, $1,252 and $825 in fiscal years 2007, 2006 and 2005, respectively.

 

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COSTCO WHOLESALE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 2—Short-term Investments (Continued)

 

The following tables present the length of time available-for-sale securities were in continuous unrealized loss positions, but were not deemed to be other-than-temporarily impaired:

 

     Less than 12 Months    Greater than or Equal
to 12 Months

September 2, 2007

   Gross
Unrealized
Holding
Losses
    Fair Value    Gross
Unrealized
Holding
Losses
    Fair Value

U.S. government and agency securities

   $ (49 )   $ 30,572    $ (905 )   $ 175,765

Corporate notes and bonds

     (128 )     15,302      (942 )     106,460

Asset and mortgage backed securities

     (112 )     20,081      (258 )     20,014
                             
   $ (289 )   $ 65,955    $ (2,105 )   $ 302,239
                             

September 3, 2006

                     

U.S. government and agency securities

   $ (1,879 )   $ 278,360    $ (3,751 )   $ 282,033

Corporate notes and bonds

     (1,251 )     193,902      (1,534 )     103,907

Asset and mortgage backed securities

     (83 )     16,485      (401 )     21,802
                             
   $ (3,213 )   $ 488,747    $ (5,686 )   $ 407,742
                             

Gross unrealized holding losses of $289 for investments held less than twelve months and $2,105 for investments held greater than or equal to twelve months as of September 2, 2007, pertain to 56 and 176 fixed income securities, respectively, and were primarily attributable to changes in interest rates. The Company currently has the financial ability to hold short-term investments with an unrealized loss until maturity and not incur any recognized losses. Management does not believe any unrealized losses represent an other-than-temporary impairment based on an evaluation of available evidence as of September 2, 2007.

The maturities of available-for-sale and held-to-maturity debt securities at September 2, 2007 are as follows:

 

     Available-For-Sale    Held-To-Maturity
     Cost Basis    Fair Value    Cost Basis    Fair Value

Due in one year or less

   $ 282,058    $ 280,724    $ 78,563    $ 78,563

Due after one year through five years

     173,063      173,176          

Due after five years

     43,426      43,324          
                           
   $ 498,547    $ 497,224    $ 78,563    $ 78,563
                           

Note 3—Debt

Bank Credit Facilities and Commercial Paper Programs (all amounts stated in U.S. dollars)

A wholly-owned Canadian subsidiary has a $189,789 commercial paper program ($180,900 at September 3, 2006) supported by a $113,874 bank credit facility ($54,200 at September 3, 2006) with a Canadian bank, which is guaranteed by the Company and expires in March 2008. At September 2, 2007 and September 3, 2006, no amounts were outstanding under the Canadian commercial paper

 

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COSTCO WHOLESALE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 3—Debt (Continued)

 

program or the bank credit facility. Applicable interest rates on the credit facility at September 2, 2007 and September 3, 2006 were 5.00% and 4.65%, respectively. At September 2, 2007, standby letters of credit totaling $24,122 issued under the bank credit facility left $89,752 available for commercial paper support. At September 3, 2006, standby letters of credit totaling $20,800 issued under the bank credit facility left $33,400 available for commercial paper support.

The Company’s wholly-owned Japanese subsidiary has a short-term $38,750 bank line of credit ($12,800 at September 3, 2006) that expires in February 2008. At September 2, 2007 and September 3, 2006, $10,333 and $2,500 respectively, were borrowed under the line of credit, and $8,611 and $4,300, respectively, were used to support standby letters of credit. Applicable interest rates on the credit facility at September 2, 2007 and September 3, 2006, were 1.09% and 0.94%, respectively. A second $30,139 bank line of credit also expires in February 2008. At September 2, 2007 and September 3, 2006, $7,750 and $900, respectively, were borrowed under the second facility. Applicable interest rates on the second credit facility at September 2, 2007 and September 3, 2006, were 1.10% and 0.95%, respectively.

The Company’s Korean subsidiary has a short-term $12,792 bank line of credit ($12,500 at September 3, 2006), which expires in March 2008. At September 2, 2007 and September 3, 2006, no amounts were borrowed under the line of credit and $2,011 and $2,000, respectively, were used to support standby letters of credit. Applicable interest rates on the credit facility at September 2, 2007 and September 3, 2006 were 6.09% and 5.48%, respectively.

The Company’s Taiwan subsidiary has a $6,062 bank revolving credit facility ($5,200 at September 3, 2006) and a $3,031 bank overdraft facility both expiring in January 2008. At September 2, 2007 and September 3, 2006, no amounts were outstanding under the credit facility or bank overdraft and $1,212 and $1,900, respectively, were used to support standby letters of credit. Applicable interest rates on the credit facility at September 2, 2007 and September 3, 2006, were 4.50% and 4.00%, respectively. A second $15,154 bank revolving credit facility is in place, which expires in July 2008. At September 2, 2007 and September 3, 2006, no amounts were borrowed under the second credit facility and $4,167 and $2,000, respectively, were used to support standby letters of credit. Applicable interest rates on the credit facility at September 2, 2007 and September 3, 2006, were 4.44% and 4.00%, respectively. A third $9,093 bank revolving credit facility is in place, which expires in March 2008. At September 2, 2007, no amounts were borrowed under the third credit facility and no amounts were used to support standby letters of credit. Applicable interest rate on the credit facility at September 2, 2007 was 4.57%.

The Company’s wholly-owned United Kingdom subsidiary has a $80,560 bank revolving credit facility ($113,900 at September 3, 2006) expiring in February 2010, a $70,490 bank overdraft facility ($66,500 at September 3, 2006) renewable on a yearly basis in May 2008 and a $40,280 uncommitted money market line entered into in February 2007 and renewable on a yearly basis beginning in May 2008. At September 2, 2007, $20,140 was outstanding under the revolving credit facility with an applicable interest rate of 6.23%, $15,609 was outstanding under the uncommitted line with an applicable interest rate of 6.47% and no amounts were outstanding under the bank overdraft facility with an applicable interest rate of 6.75%. At September 3, 2006, $38,000 was outstanding under the revolving credit facility, with an applicable interest rate of 5.32%, and no amounts were outstanding under the bank overdraft facility.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 3—Debt (Continued)

 

Letters of Credit

The Company has letter of credit facilities (for commercial and standby letters of credit) totaling $474,920. The outstanding commitments under these facilities at September 2, 2007 and September 3, 2006 totaled $119,074 and $84,900, respectively, including $71,734 and $54,900, respectively, in standby letters of credit.

Short-Term Borrowings

The weighted average borrowings, maximum borrowings and weighted average interest rate under all short-term borrowing arrangements were as follows for fiscal 2007 and 2006:

 

Category of Aggregate

Short-term Borrowings

   Maximum Amount
Outstanding
During the Fiscal Year
  

Average Amount

Outstanding

During the Fiscal Year

   Weighted Average
Interest Rate
During the Fiscal Year
 

Fiscal year ended September 2, 2007

        

Bank borrowings:

        

Canada

   $ 103,599    $ 37,809    4.63 %

United Kingdom

     77,732      40,532    5.75  

Japan

     18,031      10,103    1.00  

Bank overdraft facility:

        

United Kingdom

     34,922      6,002    6.16  

Other:

        

United Kingdom Money Market Line Borrowing

     39,624      13,301    5.99  

Fiscal year ended September 3, 2006

        

Bank borrowings:

        

Canada

   $ 11,254    $ 313    5.32 %

United Kingdom

     61,852      38,179    5.06  

Japan

     17,850      10,463    0.74  

Bank overdraft facility:

        

United Kingdom

     13,100      1,892    5.51  

Long-Term Debt

Long-term debt at September 2, 2007 and September 3, 2006 consisted of the following:

 

     2007    2006

5.5% Senior Notes due March 2017

   $ 1,094,376    $

5.3% Senior Notes due March 2012

     897,770     

3.5% Zero Coupon convertible subordinated notes due August 2017

     47,826      88,028

0.92% Promissory notes due April 2010

     34,444      34,069

2.070% Promissory notes due October 2007

     30,139      29,810

1.187% Promissory notes due July 2008

     25,833      25,551

0.88% Promissory notes due November 2009

     25,833      25,551

5.5% Senior Notes due March 2007

          301,243

Capital lease obligations and other

     11,662      19,640
             

Total long-term debt

     2,167,883      523,892

Less current portion

     59,905      308,523
             

Long-term debt, excluding current portion

   $ 2,107,978    $ 215,369
             

 

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COSTCO WHOLESALE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 3—Debt (Continued)

 

On February 20, 2007, the Company issued $900,000 of 5.3% Senior Notes due March 15, 2012 (2012 Notes) at a discount of $2,493 and $1,100,000 of 5.5% Senior Notes due March 15, 2017 (2017 Notes) at a discount of $5,940 (together the 2007 Senior Notes). Interest on the 2007 Senior Notes is payable semi-annually on March 15 and September 15 of each year, with the first payment due September 15, 2007. The net proceeds were used, in part, to repay the 5.5% 2002 Senior Notes due in March 2007, and the balance has been and will be used for general corporate purposes, including repurchases of the Company’s common stock. The $8,433 discount and $1,963 issuance costs associated with the Senior Notes are being amortized to interest expense over the terms of those notes.

The Company, at its option, may redeem the 2007 Senior Notes at any time, in whole or in part, at a redemption price plus accrued interest up to the redemption date. The redemption price is equal to the greater of 100% of the principal amount of the 2007 Senior Notes to be redeemed, or the sum of the present values of the remaining scheduled payments of principal and interest to maturity. Additionally, the Company will be required to make an offer to purchase the 2007 Senior Notes at a price of 101% of the principal amount plus accrued and unpaid interest to the date of repurchase, upon certain events as defined by the terms of the 2007 Senior Notes.

In April 2003, the Company’s wholly-owned Japanese subsidiary issued promissory notes bearing interest at 0.92% in the aggregate amount of $34,444, through a private placement. Interest is payable semi-annually and principal is due in April 2010. In November 2002, the Company’s wholly-owned Japanese subsidiary issued promissory notes bearing interest at 0.88% in the aggregate amount of $25,833, through a private placement. Interest is payable semi-annually and principal is due in November 2009. In July 2001, the Company’s wholly-owned Japanese subsidiary issued 1.187% promissory notes in the aggregate amount of $25,833, through a private placement. Interest is payable semi-annually and principal is due in July 2008. In October 2000, the Company’s wholly-owned Japanese subsidiary issued 2.07% promissory notes in the aggregate amount of $30,139, through a private placement. Interest is payable annually and principal is due in October 2007 and will be refinanced. As of September 2, 2007, the 1.187% and the 2.07% promissory notes are reported in the current portion of long-term debt on the consolidated balance sheets. The Company guarantees all of the promissory notes issued by its wholly-owned Japanese subsidiary.

In August 1997, the Company completed the sale of $900,000 principal amount at maturity of 3.5% Zero Coupon Convertible Subordinated Notes (Zero Coupon Notes) due in August 2017. The Zero Coupon Notes were priced with a yield to maturity of 3.5%, resulting in gross proceeds to the Company of $449,640. The current Zero Coupon Notes outstanding are convertible into a maximum of 1,535,907 shares of Costco Common Stock shares at an initial conversion price of $22.71. Holders of the Zero Coupon Notes may require the Company to purchase the Zero Coupon Notes (at the discounted issue price plus accrued interest to date of purchase) in August 2012. The Company, at its option, may redeem the Zero Coupon Notes (at the discounted issue price plus accrued interest to date of redemption) any time in or after August 2002. As of September 2, 2007, $832,383 in principal amount of the Zero Coupon Notes had been converted by note holders to shares of Costco Common Stock, of which $61,173 and $286,456 in principal were converted in fiscal 2007 and 2006, respectively, or $42,330 and $188,935 in fiscal 2007 and 2006, respectively, after factoring in the related debt discount.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 3—Debt (Continued)

 

At September 2, 2007, the fair value of the Zero Coupon Notes, based on market quotes, was approximately $94,326, the fair value of the 2012 Notes and 2017 Notes was $912,330 and $1,115,917, respectively, and the fair value of other long-term debt approximated its carrying value.

Maturities of long-term debt during the next five fiscal years and thereafter are as follows:

 

2008

   $ 59,905

2009

     1,248

2010

     60,879

2011

     464

2012

     897,992

Thereafter

     1,147,395
      

Total

   $ 2,167,883
      

Note 4—Leases

The Company leases land and/or buildings at 104 of the 488 warehouses open at September 2, 2007, and certain other office and distribution facilities under operating leases. The remaining terms of these operating leases range from approximately one to 41 years, with the exception of one lease in the U.S. that has a remaining life of 77 years and one lease in the Company’s United Kingdom subsidiary, which has a remaining lease term of 144 years. These leases generally contain one or more of the following options which the Company can exercise at the end of the initial lease term: (a) renewal of the lease for a defined number of years at the then-fair market rental rate or rate stipulated in the lease agreement; (b) purchase of the property at the then-fair market value; or (c) right of first refusal in the event of a third party purchase offer. Certain leases provide for periodic rental increases based on the price indices, and some of the leases provide for rents based on the greater of minimum guaranteed amounts or sales volume. Contingent rents have not been material. The Company accounts for its leases with step-rent provisions on a straight-line basis over the original term of the lease.

Aggregate rental expense for fiscal 2007, 2006 and 2005 was $143,448, $134,406 and $127,770, respectively. The amount for 2005 excludes $15,999 in rent expense associated with the correction made in the second quarter of fiscal 2005 to the Company’s method of accounting for ground leases that did not require rental payments during the period of construction.

The Company has sub-leases related to certain of its operating lease agreements. During fiscal 2007, 2006 and 2005, the Company recognized sub-lease income of $9,008, $9,425 and $7,773, respectively, included in interest income and other in the consolidated statements of income.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 4 —Leases (Continued)

 

Future minimum payments, net of sub-lease income of $149,407 for all years combined, during the next five fiscal years and thereafter under non-cancelable leases with terms of at least one year, at September 2, 2007, were as follows:

 

2008

   $ 137,225

2009

     127,068

2010

     115,393

2011

     110,750

2012

     98,973

Thereafter

     1,305,035
      

Total minimum payments

   $ 1,894,444
      

Note 5—Stockholders’ Equity

Dividends

In fiscal 2007, the Company paid quarterly cash dividends totaling $0.55 per share. In fiscal 2006, the Company paid quarterly cash dividends totaling $0.49 per share. The Company’s current quarterly dividend rate is $0.145 per share or $0.58 per share on an annualized basis.

Payment of future dividends is subject to declaration by the Board of Directors. Factors considered in determining the size of the dividends are profitability and expected capital needs of the Company. The Company presently expects to continue to pay dividends on a quarterly basis.

Stock Repurchase Programs

In January and July of 2006, the Company’s Board of Directors approved additional stock repurchases of $1,000,000 and $2,000,000, respectively, which expire in 2009, bringing total authorizations since inception of the program in fiscal 2001 to $4,500,000. Subsequent to the end of fiscal 2007, the Board of Directors approved an additional $300,000 for stock repurchases, which expires in 2010.

During fiscal 2007, the Company repurchased 36,390,000 shares at an average price of $54.39, totaling approximately $1,979,170, including commissions. During fiscal 2006, the Company repurchased 28,407,000 shares of common stock at an average price of $51.44, totaling approximately $1,461,217, including commissions. Purchases are made from time-to-time as conditions warrant in the open market or in block purchases, or pursuant to share repurchase plans under SEC Rule 10b5-1. Repurchased shares are retired.

These amounts differ from the stock repurchase balances in the statements of cash flows due to repurchases that are accrued at year-end. As of September 2, 2007, under current Board authorizations, the Company had $646,364 available for additional share repurchases.

Comprehensive Income

Comprehensive income includes net income, plus certain other items that are recorded directly to stockholders’ equity. Accumulated other comprehensive income reported on the Company’s consolidated balance sheets consists of foreign currency translation adjustments and unrealized gains and losses on short-term investments.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 5—Stockholders’ Equity (Continued)

 

The following table shows the components of comprehensive income, net of related tax effects:

 

     September 2,
2007
    September 3,
2006
    August 28,
2005
 

Unrealized gain (loss) on short-term investments

   $ 6,455     $ (540 )   $ (7,097 )

Tax (provision) benefit

     (2,421 )     210       2,719  
                        

Unrealized gain (loss) on short term investments, net of tax

     4,034       (330 )     (4,378 )

Foreign currency translation adjustment and other

     93,678       123,642       152,310  

Tax provision on translation gain in relation to earnings subject to repatriation

     (4,386 )     (4,088 )     (6,037 )
                        

Comprehensive income adjustments, net

     93,326       119,224       141,895  

Net income

     1,082,772       1,103,215       1,063,092  
                        

Total comprehensive income

   $ 1,176,098     $ 1,222,439     $ 1,204,987  
                        

The favorable translation adjustments during fiscal years 2007, 2006 and 2005 were primarily due to stronger foreign currencies.

The components of accumulated other comprehensive income, net of tax, were as follows:

 

     September 2,
2007
    September 3,
2006
 

Unrealized losses on short-term investments

   $ (815 )   $ (4,849 )

Foreign currency translation adjustment and other

     371,404       282,112  
                

Accumulated other comprehensive income

   $ 370,589     $ 277,263  
                

Note 6—Stock-Based Compensation Plans

Through the first quarter of fiscal 2006, the Company granted stock options under the Amended and Restated 2002 Stock Incentive Plan (Second Restated 2002 Plan) and predecessor plans, and since the fourth quarter of fiscal 2006, the Company has granted restricted stock units (RSUs) under the Second Restated 2002 Plan. Stock options generally vest over five years and have a ten-year term. The Company issues new shares of common stock upon exercise of stock options and vesting of RSUs.

In conjunction with the adoption of SFAS 123 at the beginning of fiscal 2003, the Company changed its method of attributing the value of stock-based compensation expense from the graded-vesting method to the straight-line method. Under the graded-vesting method, an award is accounted for as multiple awards, based on the number of vesting tranches, each tranche with a different requisite service period. The effect of graded-vesting attribution is to recognize more compensation expense in the early years of the overall vesting period. Compensation expense for all stock-based awards granted prior to fiscal 2003 will continue to be recognized using the graded-vesting method, while compensation expense for all stock-based awards granted subsequent to fiscal 2002 is being recognized using the straight-line method. SFAS 123R requires the estimation of the number of stock-based awards that will

 

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COSTCO WHOLESALE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 6—Stock-Based Compensation Plans (Continued)

 

ultimately not complete their vesting requirements (forfeitures), and requires that the compensation expense recognized equals or exceeds the number of stock-based awards vested. While options and RSUs generally vest over five years with an equal amount vesting on each anniversary of the grant date, the Company’s plans allow for daily vesting of the pro-rata number of stock-based awards that would vest on the next anniversary of the grant date in the event of retirement or voluntary termination. As such, the Company does not reduce stock-based compensation for an estimate of forfeitures because this would result in less compensation expense recognized than the number of stock-based awards vested. The impact of actual forfeitures arising in the event of involuntary termination is recognized as actual forfeitures occur.

Summary of Stock Option Activity

The following table summarizes stock option transactions during fiscal 2007:

 

    

Shares

(in 000’s)

    Weighted-
Average
Exercise
Price
   Weighted-
Average
Remaining
Contractual
Term (in
Years)
   Aggregate
Intrinsic
Value(1)

Outstanding at September 3, 2006

   39,868     $ 37.57      

Granted

              

Exercised

   (9,511 )     34.17      

Forfeited or expired

   (269 )     40.80      
                        

Outstanding at September 2, 2007

   30,088       39.26    5.37    $ 676,594
                        

Exercisable at September 2, 2007

   19,283     $ 38.35    4.43    $ 451,196
                        

(1) The difference between the exercise price and market value at September 2, 2007.

The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in 2006 and 2005:

 

     2006     2005  

Expected volatility

     28 %     38 %

Expected term

     5.2 years       6.6 years  

Risk free interest rate

     4.33 %     4.28 %

Expected dividend yield

     0.99 %     1.11 %

Weighted-average fair value per option granted

   $ 13.87     $ 18.01  

In fiscal 2006, the expected volatility was based primarily on the historical volatility of the Company’s stock and, to a lesser extent, the six-month implied volatility of its traded options. Prior to the adoption of SFAS 123R, expected stock price volatility was estimated using only historical volatility. In fiscal 2006, the expected term was the average of the life of all historical grants that have been exercised and the term at which the historical average intrinsic gain is reached. Prior to adoption of SFAS 123R, the expected term was calculated as the average term between grant and exercise dates for those

 

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COSTCO WHOLESALE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except per share data) (Continued)

Note 6—Stock-Based Compensation Plans (Continued)

 

options where at least 40% of the original grant was exercised. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant with an equivalent remaining term. The expected dividend yield is based on the annual dividend rate at the time of the grant.

The following is a summary of stock options outstanding as of September 2, 2007 (number of options in thousands):