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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended February 15, 2004

 

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 office) (Zip Code)

 

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

 

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 whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).  YES  x    NO  ¨

 

The number of shares outstanding of the registrant’s common stock as of March 19, 2004 was 458,989,826.

 



Table of Contents

COSTCO WHOLESALE CORPORATION

 

INDEX TO FORM 10-Q

 

PART I—FINANCIAL INFORMATION
     Page

ITEM 1—FINANCIAL STATEMENTS

   3

Condensed Consolidated Balance Sheets

   14

Condensed Consolidated Statements of Income

   15

Condensed Consolidated Statements of Cash Flows

   16

Notes to Condensed Consolidated Financial Statements

   17

ITEM 2—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

   3

ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

   11

ITEM 4—CONTROLS AND PROCEDURES

   11
PART II—OTHER INFORMATION

ITEM 1—LEGAL PROCEEDINGS

   11

ITEM 2—CHANGES IN SECURITIES, USE OF PROCEEDS, AND ISSUER PURCHASES OF EQUITY SECURITIES

   11

ITEM 3—DEFAULTS UPON SENIOR SECURITIES

   11

ITEM 4—SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

   12

ITEM 5—OTHER INFORMATION

   12

ITEM 6—EXHIBITS AND REPORTS ON FORM 8-K

   13

SIGNATURES

   13

Exhibit (31.1) Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

    

Exhibit (31.2) Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

    

Exhibit (99) Independent Accountants’ Review Report

    

 

2


Table of Contents

PART I—FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

Costco Wholesale Corporation’s (“Costco” or the “Company”) unaudited condensed consolidated balance sheets as of February 15, 2004, and August 31, 2003, the unaudited condensed consolidated statements of income for the 12-week and 24-week periods ended February 15, 2004 and February 16, 2003 and the unaudited condensed consolidated statements of cash flows for the 24-week periods ended February 15, 2004 and February 16, 2003, are included elsewhere herein. Also included elsewhere herein are notes to the unaudited condensed consolidated financial statements and the results of the review of the unaudited financial statements as of February 15, 2004, and for the 12-week and 24-week periods ended February 15, 2004 and February 16, 2003, performed by KPMG LLP, independent public accountants.

 

The Company reports on a 52/53-week fiscal year, consisting of 13 four-week periods and ending on the Sunday nearest the end of August. Fiscal 2004 is a 52-week year with period 13 ending on August 29, 2004, with the first, second and third quarters consisting of 12 weeks each and the fourth quarter consisting of 16 weeks. Fiscal 2003 was a 52-week year that ended on August 31, 2003, with the first, second and third quarters consisting of 12 weeks each and the fourth quarter consisting of 16 weeks.

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Forward-looking Statements

 

Certain statements contained in this document constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. For these purposes, forward-looking statements are statements that address activities, events, conditions or developments that the Company expects or anticipates may occur in the future. Such forward-looking statements involve risks and uncertainties that may cause actual events, results or performance to differ materially from those indicated by such statements. These risks and uncertainties include, but are not limited to, domestic and international economic conditions including exchange rates, the effects of competition and regulation, consumer and small business spending patterns and debt levels, conditions affecting the acquisition, development, ownership or use of real estate, actions of vendors, rising costs associated with employees (including health care and workers’ compensation costs), geopolitical conditions and other risks identified from time to time in the Company’s public statements and reports filed with the Securities and Exchange Commission.

 

It is suggested that this management discussion be read in conjunction with the management discussion included in the Company’s fiscal 2003 annual report on Form 10-K previously filed with the Securities and Exchange Commission.

 

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

 

Overview

 

Costco operates membership warehouses based on the concept that offering 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 Costco to operate profitably at significantly lower gross margins than traditional wholesalers, discount retailers and supermarkets.

 

At February 15, 2004, Costco operated 430 warehouse clubs: 318 in the United States; 62 in Canada; 15 in the United Kingdom; five in Korea; three in Taiwan; four in Japan; and 23 warehouses in Mexico with a joint venture partner. The 23 Mexico warehouses are not consolidated, but are accounted for on an equity basis.

 

3


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

(Continued)

 

Net income for the second quarter of fiscal 2004 increased 24.6% to $226,792, or $.48 per diluted share, compared to $182,065, or $.39 per diluted share, during the second quarter of fiscal 2003. Included in the second quarter fiscal 2003 operating results was a pre-tax charge of $26,000 ($16,000, or $.03 per share after tax), reflecting an increase in workers’ compensation loss reserves.

 

Net income for the first half of fiscal 2004 increased 18.1% to $386,967, or $.82 per diluted share, compared to $327,794, or $.70 per diluted share, during the first half of fiscal 2003.

 

SELECTED CONSOLIDATED STATEMENTS OF INCOME DATA

 

The table below presents selected operational data, the percentage relationship between net sales and major categories in the Condensed Consolidated Statements of Income and the percentage change in the dollar amounts of each of the items.

 

     Twelve Weeks Ended

    Twenty-Four Weeks Ended

   

Percentage
Increase/(Decrease)

(in dollar amounts)


 
     February 16,
2003


    February 15,
2004


    February 16,
2003


    February 15,
2004


    Twelve
Weeks


    Twenty-four
Weeks


 

Net sales

   100.00 %   100.00 %   100.00 %   100.00 %   14.2 %   14.3 %

Membership fees

   1.95     1.93     2.02     1.99     12.9     12.7  

Gross margin (A)

   10.89     10.84     10.78     10.71     13.7     13.5  

Selling, general and administrative

   9.75     9.57     9.80     9.78     12.2     14.1  

Preopening expenses

   0.07     0.04     0.13     0.07     (41.0 )   (43.2 )

Provision for impaired assets and closing costs

   0.05     0.03     0.06     0.03     (33.3 )   (26.3 )
    

 

 

 

 

 

Operating income

   2.97     3.13     2.81     2.82     20.4     14.5  
    

 

 

 

 

 

Interest expense

   0.08     0.07     0.09     0.08     3.2     1.6  

Interest income and other

   0.09     0.12     0.09     0.10     45.5     26.2  
    

 

 

 

 

 

Income before income taxes

   2.98     3.18     2.81     2.84     21.6     15.2  

Provision for income taxes

   1.14     1.18     1.08     1.05     16.9     10.8  
    

 

 

 

 

 

Net Income

   1.84 %   2.00 %   1.73 %   1.79 %   24.6 %   18.1 %
    

 

 

 

 

 


(A) Defined as Net sales less Merchandise costs.

 

Net Sales

 

Net sales increased 14.2% to $11,330,214 during the second quarter of fiscal 2004, from $9,920,324 during the second quarter of fiscal 2003. For the first half of fiscal 2004, net sales increased 14.3% to $21,640,036, from $18,930,895 during the first half of fiscal 2003. These increases were due to an increase in comparable warehouse sales, which accounted for approximately 80% of the sales increases, and to the opening of a net 16 new warehouses (20 opened, 4 closed) since the end of the second quarter of fiscal 2003, which accounted for the remaining approximately 20% of the sales increases.

 

For the second quarter of fiscal 2004, comparable sales, that is, sales in warehouses open for at least one year, increased 11% over the second quarter of fiscal 2003 and increased 11% for the first half of fiscal 2004 over the first half of fiscal 2003.

 

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Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

(Continued)

 

Changes in prices of merchandise did not materially affect the sales increases. Translation of foreign sales into U.S. dollars contributed to the increase in sales due to the stronger foreign currencies, accounting for an increase in total and comparable sales of approximately 270 basis points for both the quarter and the first half of fiscal 2004. In addition, warehouse sales were positively impacted by the supermarket strikes in California, since October 12, 2003. The supermarket strike’s positive impact to sales was estimated to be in the range of 75 to 100 basis points. On March 7, 2004, union employees of these supermarkets voted to accept management’s offer and end the strike; and in the subsequent two weeks they began returning to work.

 

Membership Fees

 

Membership fees and other revenue increased 12.9% to $218,760, or 1.93% of net sales, in the second quarter of fiscal 2004 from $193,843, or 1.95% of net sales, in the second quarter of fiscal 2003 and increased 12.7% to $430,416, or 1.99% of net sales, in the first half of fiscal 2004 from $381,857, or 2.02% of net sales, in the first half of fiscal 2003. Increases in membership fee income reflected new membership sign-ups, both at new warehouses opened since the end of the second quarter of fiscal 2003 and at existing warehouses; increased penetration of the Company’s Executive Membership, including the rollout of this program into Canada, which began in the first quarter of fiscal 2004; and high overall member renewal rates (currently 86%) consistent with recent year’s renewal rates.

 

Gross Margin

 

Gross margin (defined as net sales less merchandise costs) increased 13.7% to $1,228,237, or 10.84% of net sales, in the second quarter of fiscal 2004 from $1,079,913, or 10.89% of net sales, in the second quarter of fiscal 2003. The five basis point decrease in gross margin as a percentage of net sales reflected a reduction of two basis points in the Company’s warehouse and ancillary businesses gross margin. Gross margins increased year-over-year in many of the Company’s merchandise categories (such as Food and Sundries, Hardlines and Fresh Foods), but declined slightly overall due to weaker year-over-year Softlines margins and changes in sales mix. Other factors impacting gross margin included an eight basis point increase in margin caused by a change in the timing of the recognition of some vendor allowances in complying with the Emerging Issues Task Force (EITF) Issue No. 02-16; and a reduction in gross margin by 11 basis points due to the increased costs related to the Executive Membership Two-Percent Reward Program; the latter, due to an increase in the penetration of the Executive Member purchases, including the recent rollout of the program in Canada.

 

Gross margin increased 13.5% to $2,317,937, or 10.71% of net sales, in the first half of fiscal 2004 from $2,041,587, or 10.78% of net sales, in the first half of fiscal 2003. The seven basis point, year-to-date decrease in gross margin as a percentage of net sales reflected a 13 basis point increase in the Company’s warehouse and ancillary businesses gross margin, which was significantly impacted by strong year-over-year increases in both gasoline sales and gasoline gross margin. This increase by 13 basis points year-over-year in gross margin was offset by a ten basis point decrease in margin caused by a change in the timing of the recognition of some vendor allowances (EITF 02-16). Additionally, a reduction in gross margin by ten basis points was due to the increased costs related to the Executive Membership Two-Percent Reward Program, resulting from an increase in the penetration of the Executive Member purchases, including the recent rollout of the program in Canada.

 

The gross margin figures reflect accounting for most U.S. merchandise inventories on the last-in, first-out (LIFO) method. No change in the LIFO provision was made in the second quarters of both fiscal 2004 and fiscal 2003, as well as the first half of both fiscal 2004 and 2003.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses as a percent of net sales decreased to 9.57% during the second quarter of fiscal 2004 from 9.75% during the second quarter of fiscal 2003; and decreased to 9.78% during the

 

5


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

(Continued)

 

first half of fiscal 2004 from 9.80% during the first half of fiscal 2003. These decreases were primarily due to a reduction in workers’ compensation charges, as the Company incurred a $26,000 pre-tax charge in the second quarter of fiscal 2003, reflecting an increase in workers’ compensation loss reserves as a result of an adverse development of prior year’s loss costs and other developments indicating continued trends of rising claim costs, predominantly in the State of California. This prior year workers’ compensation charge accounted for a 23 basis point decrease in SG&A expenses for the second quarter, and an 11 basis point decrease for the first half of fiscal 2004 year-over-year.

 

Additionally, for both the second quarter and the first half of fiscal 2004, warehouse payroll and utility costs also positively impacted SG&A comparisons year-over-year by approximately nine basis points quarter-over-quarter and ten basis points for the first half of fiscal 2004. This decrease was partially offset with increases in healthcare and other benefits related costs, which accounted for a six and ten basis point increase for the quarter and first half of fiscal 2004, respectively, and in stock-based compensation costs of approximately five basis points for both the quarter and first half of fiscal 2004.

 

Preopening Expenses

 

Preopening expenses totaled $4,216, or .04% of net sales, during the second quarter of fiscal 2004 compared to $7,145, or .07% of net sales, during the second quarter of fiscal 2003. One warehouse was opened in the second quarter of fiscal 2004 compared to five warehouses opened during last year’s second quarter. Preopening costs per warehouse were not appreciably higher in fiscal 2004 as the Company incurred preopening costs in fiscal 2004 for one warehouse that opened four days subsequent to the quarter ended February 15, 2004 and the Company incurred slightly higher costs for remodels in fiscal 2004 than in fiscal 2003.

 

Preopening expenses totaled $14,341, or .07% of net sales, during the first half of fiscal 2004 compared to $25,262, or .13% of net sales, during the first half of fiscal 2003. Ten warehouses (including one relocation) were opened in the first half of fiscal 2004 compared to 19 warehouses (including two relocated warehouses) opened during last fiscal year’s first half.

 

 

Provision for Impaired Assets and Closing Costs

 

The provision for impaired assets and closing costs totaled $3,000 in the second quarter of fiscal 2004 compared to $4,500 in the second quarter of fiscal 2003 and totaled $7,000 in the first half of fiscal 2004 compared to $9,500 in the first half of fiscal 2003. Both fiscal 2004 and 2003 provisions include costs related to impairment of long-lived assets, future lease obligations of warehouses that have been relocated to new facilities, and any losses or gains resulting from the sale of real property.

 

Interest Expense

 

Interest expense totaled $8,261 in the second quarter of fiscal 2004 compared to $8,003 in the second quarter of fiscal 2003 and totaled $16,736 in the first half of fiscal 2004 compared to $16,471 in the first half of fiscal 2003. Interest expense in both fiscal 2004 and fiscal 2003 primarily includes interest on the 71/8% and 51/2% Senior Notes, the 31/2 % Zero Coupon Notes and on balances outstanding under the Company’s bank credit facilities and promissory notes. The increase is primarily related to the reduction in interest capitalized related to warehouse construction, as the overall cost of projects under construction has been lower in fiscal 2004 than in fiscal 2003.

 

Interest Income and Other

 

Interest income and other totaled $13,072 in the second quarter of fiscal 2004 compared to $8,983 in the second quarter of fiscal 2003 and totaled $20,975 in the first half of fiscal 2004 compared to $16,617 in the first

 

6


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

(Continued)

 

half of fiscal 2003. This increase primarily reflects increased interest income resulting from higher cash and cash equivalents balances and short-term investments on hand throughout the first half of fiscal 2004 as compared to the first half of fiscal 2003. In addition, year-over-year earnings increases in Costco Mexico, the Company’s 50%-owned joint venture, positively impacted this change.

 

Provision for Income Taxes

 

The effective income tax rate on earnings in both the second quarter and first half of fiscal 2004 was 37%, compared to 38.5% in both the second quarter and first half of fiscal 2003, primarily attributable to lower statutory income tax rates for foreign operations.

 

Liquidity and Capital Resources (dollars in thousands)

 

Cash Flows

 

Cash flow generated from warehouse operations provides a significant source of liquidity. Net cash provided by operating activities totaled $1,272,684 in the first half of fiscal 2004 compared to $906,513 in the first half of fiscal 2003. The increase of $366,171 is primarily a result of an increase in the change in receivables, other current assets, deferred income and accrued and other current liabilities of $337,440, due primarily to the collection of an operating tax receivable and increases in the healthcare cost accrual and deferred vendor allowances in the first half of fiscal 2004 compared to the same period of fiscal 2003.

 

The primary component of net cash used in investing activities continues to be the purchase of property and equipment related to the Company’s warehouse expansion and remodel projects. Net cash used in investing activities totaled $532,513 in the first half of fiscal 2004 compared to $443,708 in the first half of fiscal 2003, an increase of $88,805. The increase in investing activities primarily relates to an increase in short-term investments of $111,709 and the purchase of a 20% minority interest in Costco Wholesale UK Limited of $95,153; which was partially offset by a reduction in the acquisition of property and equipment and the construction of facilities for new and remodeled warehouses of $118,305 between the first half of fiscal 2004 and fiscal 2003, as new warehouse openings decreased year-over-year from 19 (including two relocated warehouses) in fiscal 2003 to 10 in fiscal 2004.

 

Net cash used in financing activities totaled $131,969 in the first half of fiscal 2004 compared to $105,579 in the first half of fiscal 2003. The increase of $26,390 primarily resulted from a decrease in long-term borrowings year-over-year.

 

Expansion Plans

 

Costco’s primary requirement for new capital is for the financing of the land, building and equipment costs for new warehouses plus the costs of initial warehouse operations and working capital requirements, as well as additional capital for international expansion through investments in foreign subsidiaries and joint ventures.

 

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 an aggregate of approximately $700,000 to $800,000 during fiscal 2004 in the United States and Canada for real estate, construction, remodeling and equipment for warehouse clubs and related operations; and approximately $50,000 to $100,000 for international expansion, including the United Kingdom, Asia, Mexico and other potential ventures. Through the end of the second quarter of fiscal 2004, expenditures of approximately $330,918 had been incurred by the Company. Future expenditures will be financed with a combination of cash provided from operations, the use of cash and cash equivalents and short-term investments (totaling $2,287,646 as of February 15, 2004), short-term

 

7


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

(Continued)

 

borrowings under revolving credit facilities and other financing sources as required. Of the $2,287,646, approximately $417,000 represented debit and credit card receivables primarily related to weekend sales immediately prior to the quarter-end close. Expansion plans for the United States and Canada during the remainder of fiscal 2004 are to open an additional eight to ten new warehouse clubs, including one to two relocations.

 

Additional Equity Investment in Subsidiary

 

On October 3, 2003, the Company acquired from Carrefour Nederland B.V. it’s 20% equity interest in Costco Wholesale UK Limited for cash of approximately $95,153, bringing Costco’s ownership in Costco Wholesale UK Limited to 100%.

 

Bank Credit Facilities and Commercial Paper Programs (all dollar amounts stated in thousands of US dollars)

 

The Company has in place a $500,000 commercial paper program supported by a $300,000 bank credit facility with a group of ten banks, of which $150,000 expires on November 9, 2004, and $150,000 expires on November 15, 2005. At February 15, 2004, no amounts were outstanding under the commercial paper program or the credit facility. Covenants related to the credit facility place limitations on total Company indebtedness. At February 15, 2004, the Company was in compliance with all covenants.

 

In addition, a wholly-owned Canadian subsidiary has a $152,000 commercial paper program supported by a $45,700 bank credit facility with a Canadian bank, which expires in March 2005. At February 15, 2004, no amounts were outstanding under the Canadian commercial paper program or the bank credit facility.

 

The Company has agreed to limit the combined amount outstanding under the U.S. and Canadian commercial paper programs to the $345,700 combined amounts of the respective supporting bank credit facilities.

 

The Company’s wholly-owned Japanese subsidiary has a short-term $28,500 bank line of credit, which expires in November 2004. At February 15, 2004, no amounts were outstanding under the line of credit.

 

The Company’s wholly-owned UK subsidiary has a $113,800 bank revolving credit facility and a $47,400 bank overdraft facility, both expiring in February 2007. At February 15, 2004, $43,615 was outstanding under the revolving credit facility and no balance was outstanding under the bank overdraft facility.

 

Letters of Credit

 

The Company has separate letter of credit facilities (for commercial and standby letters of credit) totaling approximately $374,000. The outstanding commitments under these facilities at February 15, 2004 totaled approximately $114,300, including approximately $46,000 in standby letters of credit.

 

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. The aggregate amount of foreign exchange contracts outstanding at February 15, 2004 was not material. The only significant derivative instruments the Company holds are interest rate swaps, which the Company uses to manage interest rates associated with its borrowings and to manage the Company’s mix of fixed and variable-rate debt. As of February 15, 2004, the Company had “fixed-to-floating” interest rate swaps with an aggregate notional

 

8


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

(Continued)

 

amount of $600,000 and an aggregate fair value of $38,490, which is recorded in other assets. These swaps were entered into effective November 13, 2001, and March 25, 2002, and are designated and qualify as fair value hedges of the Company’s $300,000 71/8% Senior Notes and the Company’s $300,000 51/2% Senior Notes, respectively. As the terms of the swaps match those of the underlying hedged debt, the changes in the fair value of these swaps are offset by corresponding changes in the carrying amount of the hedged debt, and result in no net earnings impact.

 

Critical Accounting Policies

 

The preparation of the Company’s financial statements requires that management make estimates and judgments that affect the financial position and results of operations. Management continues to review its accounting policies and evaluate its estimates, including those related to merchandise inventory, impairment of long-lived assets and warehouse closing costs and insurance/self-insurance liabilities. The Company bases its estimates on historical experience, outside expertise and on other assumptions and factors that management believes to be reasonable under present circumstances.

 

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. The Company considers in its calculation of the LIFO cost the estimated net realizable value of inventory in those inventory pools where deflation exists and records a write down of inventory where estimated net realizable value is less than LIFO inventory.

 

The Company provides for estimated inventory losses between physical inventory counts on the basis of a percentage of sales. The provision is adjusted periodically to reflect the trend of the actual physical inventory count results, which generally occur in the second and fourth fiscal quarters.

 

Inventory cost, where appropriate, is reduced by estimates of vendor rebates earned when those rebates are deemed to be 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 approach.

 

Impairment of Long-lived Assets and Warehouse Closing Costs

 

The Company periodically evaluates its long-lived assets for indicators of impairment. Management’s judgments are based on market and operational conditions at the present time. Future events could cause management to conclude that impairment factors exist, requiring an adjustment of these assets to their then-current fair market value.

 

The Company provides estimates for warehouse closing costs when it is appropriate to do so based on accounting principles generally accepted in the United States. Future circumstances may result in the Company’s actual future closing costs or the amount recognized upon the sale of the property to differ substantially from the original estimates.

 

9


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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

(Continued)

 

Insurance/Self-Insurance Liabilities

 

The Company uses a combination of insurance and self-insurance mechanisms to provide for the potential liabilities for workers’ compensation, general liability, property insurance, director and officers’ liability, vehicle liability and employee health care benefits. Liabilities associated with the risks that are retained by the Company are estimated, in part, by considering historical claims experience and 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.

 

Recently Issued Accounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities.” In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either does not have equity investors with voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities. Interpretation No. 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of Interpretation No. 46 apply immediately to variable interest entities created after January 31, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. In December 2003, the FASB issued Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities,” (FIN 46R) which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” which was issued in January 2003 and revised the implementation date to the first fiscal year or interim period ending after March 15, 2004, with the exception of special purpose entities. The Company is currently evaluating the potential impact the adoption of this interpretation will have on its consolidated financial statements.

 

In November 2002, the Emerging Issues Task Force (EITF) reached consensus on certain issues discussed in EITF 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor,” with respect to determining how a reseller should characterize consideration received from a vendor and when to recognize and how to measure that consideration in its income statement. Requirements for recognizing volume-based rebates are effective for arrangements entered into or modified after November 21, 2002 and resellers with other supplier payments should generally apply the new rules prospectively for agreements entered into or modified after December 31, 2002. The adoption of this consensus will not have a significant impact on the Company on an annual basis. However, the application of the consensus has resulted in a change in the timing for the recognition of some vendor allowances for certain agreements entered into subsequent to December 31, 2002 and will extend the recognition time frame beyond that which was in effect for similar contracts entered into prior to December 31, 2002. Net income for the second quarter of fiscal 2004 was positively impacted by $5,772 after-tax ($.01 per diluted share) and was negatively impacted for the year-to-date period ended February 15, 2004 by $14,593 after-tax ($.03 per diluted share) due to the adoption of EITF 02-16.

 

In November 2003, the EITF reached consensus on EITF 03-10, “Application of Issue No. 02-16 by Resellers to Sales Incentives Offered to Consumers by Manufacturers,” with respect to determining if consideration received by a reseller from a vendor that is reimbursed by the vendor for honoring the vendor’s sale incentives offered directly to consumers should be recorded as a reduction in sales. These rules apply to transactions entered into by consumers in fiscal periods beginning after November 25, 2003 and, therefore, will apply to such transactions starting with the Company’s fiscal third quarter of 2004. The adoption of EITF 03-10 will not affect the Company’s consolidated gross profit or net income, but will result in a reduction of both net sales and merchandise costs by an equal amount.

 

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Item 3. Quantitative and Qualitative Disclosure of Market Risk

 

Our exposure to financial market risk results primarily from fluctuations in interest and currency rates. There have been no material changes to our market risks as disclosed in our Annual Report on Form 10-K for the year ended August 31, 2003.

 

Item 4. Controls and Procedures

 

We carried out an evaluation as of February 15, 2004, under the supervision and with the participation of the Company’s management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14 and 15d-14. Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that as of the end of the period covered by this report, our disclosure controls and procedures are effective to timely alert them to any material information relating to the Company (including its consolidated subsidiaries) that must be included in our periodic Securities and Exchange Commission filings. There have been no significant changes in the Company’s internal controls over financial reporting or in other factors that could significantly affect internal controls over financial reporting subsequent to their evaluation.

 

The Company intends to review and evaluate the design and effectiveness of its disclosure controls and procedures on an ongoing basis and to improve its controls and procedures over time and to correct any deficiencies that may be discovered in the future in order to ensure that senior management has timely access to all material financial and non-financial information concerning the Company’s business. While management believes that the present design of the Company’s disclosure controls and procedures is effective to achieve these results, future events affecting the Company’s business may cause management to modify its disclosure controls and procedures.

 

The date for the Company to comply with the provisions of Section 404 of the Sarbanes-Oxley Act of 2002 (relating to internal controls) has been delayed by the SEC until fiscal year-end 2005.

 

PART II—OTHER INFORMATION

( dollars in thousands)

 

ITEM 1. Legal Proceedings

 

The Company is involved from time to time in claims, proceedings and litigation arising from its business and property ownership. The Company is a defendant in two actions purportedly brought as class actions on behalf of certain present and former Costco managers in California, in which plaintiffs allege that they have not been properly compensated for overtime work. Scott M. Williams v. Costco Wholesale Corporation, United States District Court (San Diego), Case No. 02-CV-2003 NAJ (JFS); Superior Court for the County of San Diego, Case No. GIC 792559; Greg Randall v. Costco Wholesale Corporation, Superior Court for the County of Los Angeles, Case No. BC 296369. Presently, claims are made under various provisions of the California Labor Code and the California Business and Professions Code. Plaintiffs seek restitution/disgorgement, compensatory damages, various statutory penalties, liquidated damages, punitive, treble and exemplary damages, and attorneys’ fees. In neither case has the Court been asked yet to determine whether the action should proceed as a class action or, if so, the definition of the class. The Company expects to vigorously defend these actions. The Company does not believe that any claim, proceeding or litigation, either alone or in the aggregate, will have a material adverse effect on the Company’s consolidated financial position or results of operations.

 

ITEM 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

 

None.

 

ITEM 3. Defaults Upon Senior Securities

 

None.

 

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Table of Contents

ITEM 4. Submission of Matters to a Vote of Security Holders

 

The Company’s annual meeting was held at 10:00 a.m. on January 29, 2004 at the Meydenbauer Center, 11100 NE 6th Street, Bellevue, Washington. Stockholders of record at the close of business on December 5, 2003 were entitled to notice of and to vote in person or by proxy at the annual meeting. At the date of record there were 457,883,192 shares outstanding. The matters presented for vote received the following total, for, against and abstained votes as noted below.

 

  (1) To elect four Class II directors to hold office until the 2007 Annual Meeting of Stockholders and until their successors are elected and qualified.

 

     Total Shares
Voted/(%)


  

For

Votes/(%)


  

Withheld Authority and

Abstained Votes/(%)


Benjamin S. Carson

   395,879,113    373,738,561    22,140,552
     86.46%    94.41%    5.59%

Hamilton E. James

   395,879,113    370,397,055    25,482,058
     86.46%    93.56%    6.44%

Jill S. Ruckelshaus

   395,879,114    371,938,275    23,940,839
     86.46%    93.95%    6.05%

William H. Gates, II

   395,879,113    373,697,031    22,182,082
     86.46%    94.40%    5.60%

 

  (2) To elect one Class I director to hold office until the 2006 Annual Meeting of Stockholders and until his successor is elected and qualifed.

 

     Total Shares
Voted/(%)


  

For

Votes/(%)


  

Withheld Authority and

Abstained Votes/(%)


Daniel J. Evans

   395,879,113    371,655,639    24,223,474
     86.46%    93.88%    6.12%

 

  (3) To consider a shareholder proposal to elect directors annually and not by classes.

 

Total Shares
Voted/(%)


  For Votes/(%)

  Against Votes/(%)

 

Withheld Authority and

Abstained Votes/(%)


308,154,642   229,310,867   73,783,466   5,060,309
67.30%   74.41%   23.95%   1.64%

 

  (4) To consider a shareholder proposal that the Board of Directors develop a policy for land procurement and use that incorporates social and environmental factors.

 

Total Shares
Voted/(%)


  For Votes/(%)

  Against Votes/(%)

 

Withheld Authority and

Abstained Votes/(%)


308,085,380

  17,952,927   258,977,512   31,154,941

67.28%

  5.83%   84.06%   10.11%

 

  (5) To consider and ratify the selection of the Company’s independent public accountants, KMPG LLP.

 

Total Shares
Voted/(%)


  For Votes/(%)

  Against Votes/(%)

 

Withheld Authority and

Abstained Votes/(%)


395,879,112   379,824,410   12,901,228   3,153,474
86.46%   95.94%   3.26%   0.80%

 

ITEM 5. Other Information

 

None.

 

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ITEM 6. Exhibits and Reports on Form 8-K

 

(a) The following exhibits are included herein or incorporated by reference:

 

(3.1)    Articles of Incorporation of the Registrant. Incorporated by reference to Form 8-K dated August 30, 1999
(3.2)    Bylaws of the Registrant. Incorporated by reference to Form 10-K dated November 17, 2000
(4.1)    Registrant will furnish upon request copies of instruments defining the rights of holders of its long-term debt instruments
(15.1)    Letter of KPMG LLP regarding unaudited financial information
(31.1)    Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
(31.2)    Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
(32.1)    Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(32.2)    Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(99)       Independent Accountants’ Review Report

 

(b) One report on Form 8-K was filed during the 12-week period ended February 15, 2004. On December 9, 2003 the Company filed a Form 8-K, which contained its press release of the financial results of the first quarter of fiscal 2004. The Company filed an 8-K on March 3, 2004, subsequent to the quarter end, which contained its press release of the financial results of the second quarter results of fiscal 2004.

 

SIGNATURES

 

Pursuant to the requirements 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.

 

COSTCO WHOLESALE CORPORATION

(Registrant)

Date: March 25, 2004

   /s/    JAMES D. SINEGAL        
    
    

James D. Sinegal

President, Chief Executive Officer

Date: March 25, 2004

   /s/    RICHARD A. GALANTI        
    
    

Richard A. Galanti

Executive Vice President,

Chief Financial Officer

 

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COSTCO WHOLESALE CORPORATION

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except par value)

(unaudited)

 

     February 15, 2004

    August 31, 2003

 

ASSETS

 

CURRENT ASSETS

                

Cash and cash equivalents

   $ 2,175,937     $ 1,545,439  

Short-term investments

     111,709       —    

Receivables, net

     308,864       556,090  

Merchandise inventories

     3,642,364       3,339,428  

Other current assets

     260,721       270,581  
    


 


Total current assets

     6,499,595       5,711,538  
    


 


PROPERTY AND EQUIPMENT

                

Land

     2,252,437       2,173,685  

Buildings, leaseholds and land improvements

     5,104,811       4,831,236  

Equipment and fixtures

     1,971,686       1,846,324  

Construction in progress

     105,739       154,181  
    


 


       9,434,673       9,005,426  

Less accumulated depreciation and amortization

     (2,231,785 )     (2,045,418 )
    


 


Net property and equipment

     7,202,888       6,960,008  
    


 


OTHER ASSETS

     574,985       520,142  
    


 


     $ 14,277,468     $ 13,191,688  
    


 


LIABILITIES AND STOCKHOLDERS’ EQUITY

 

CURRENT LIABILITIES

                

Short term borrowings

   $ 43,615     $ 47,421  

Accounts payable

     3,267,942       3,131,320  

Accrued salaries and benefits

     930,916       734,261  

Accrued sales and other taxes

     240,631       207,392  

Deferred membership income

     460,337       401,357  

Other current liabilities

     644,029       489,356  
    


 


Total current liabilities

     5,587,470       5,011,107  

LONG-TERM DEBT

     1,313,185       1,289,649  

DEFERRED INCOME TAXES AND OTHER LIABILITIES

     203,605       209,835  
    


 


Total liabilities

     7,104,260       6,510,591  
    


 


COMMITMENTS AND CONTINGENCIES

                

MINORITY INTEREST

     61,417       126,117  
    


 


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; 458,776,000 and 457,479,000 shares issued and outstanding

     2,294       2,287  

Additional paid-in capital

     1,325,975       1,280,942  

Other accumulated comprehensive income (loss)

     46,824       (77,980 )

Retained earnings

     5,736,698       5,349,731  
    


 


Total stockholders’ equity

     7,111,791       6,554,980  
    


 


     $ 14,277,468     $ 13,191,688  
    


 


 

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

 

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COSTCO WHOLESALE CORPORATION

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(dollars in thousands, except per share data)

(unaudited)

 

     12 Weeks Ended

    24 Weeks Ended

 
     February 15,
2004


    February 16,
2003


    February 15,
2004


    February 16,
2003


 

REVENUE

                                

Net sales

   $ 11,330,214     $ 9,920,324     $ 21,640,036     $ 18,930,895  

Membership fees

     218,760       193,843       430,416       381,857  
    


 


 


 


Total revenue

     11,548,974       10,114,167       22,070,452       19,312,752  

OPERATING EXPENSES

                                

Merchandise costs

     10,101,977       8,840,411       19,322,099       16,889,308  

Selling, general and administrative

     1,084,605       967,051       2,117,018       1,855,830  

Preopening expenses

     4,216       7,145       14,341       25,262  

Provision for impaired assets and closing costs

     3,000       4,500       7,000       9,500  
    


 


 


 


Operating income

     355,176       295,060       609,994       532,852  

OTHER INCOME (EXPENSE)

                                

Interest expense

     (8,261 )     (8,003 )     (16,736 )     (16,471 )

Interest income and other

     13,072       8,983       20,975       16,617  
    


 


 


 


INCOME BEFORE INCOME TAXES

     359,987       296,040       614,233       532,998  

Provision for income taxes

     133,195       113,975       227,266       205,204  
    


 


 


 


NET INCOME

   $ 226,792     $ 182,065     $ 386,967     $ 327,794  
    


 


 


 


NET INCOME PER COMMON AND
COMMON EQUIVALENT SHARE:

                                

Basic

   $ 0.49     $ 0.40     $ 0.85     $ 0.72  
    


 


 


 


Diluted

   $ 0.48     $ 0.39     $ 0.82     $ 0.70  
    


 


 


 


Shares used in calculation (000’s)

                                

Basic

     458,228       455,927       457,929       455,748  

Diluted

     481,537       478,564       480,885       478,742  

 

 

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

 

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COSTCO WHOLESALE CORPORATION

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

(unaudited)

 

     24 Weeks Ended

 
     February 15,
2004


    February 16,
2003


 

CASH FLOWS FROM OPERATING ACTIVITIES

                

Net income

   $ 386,967     $ 327,794  

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

                

Undistributed equity earnings in joint ventures

     (11,463 )     (10,310 )

Depreciation and amortization

     199,813       175,010  

Stock-based compensation

     11,853       395  

Accretion of discount on zero coupon notes

     8,374       8,089  

Net loss on sale of property and equipment and other

     313       1,632  

Provision for impaired assets

     1,500       4,829  

Change in deferred income taxes

     1,922       17,138  

Tax benefit from exercise of stock options

     7,102       4,551  

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

     684,190       346,750  

Increase in merchandise inventories

     (243,385 )     (76,490 )

Increase in accounts payable

     225,498       107,125  
    


 


Total adjustments

     885,717       578,719  
    


 


Net cash provided by operating activities

     1,272,684       906,513  
    


 


CASH FLOWS FROM INVESTING ACTIVITIES

                

Additions to property and equipment

     (330,918 )     (449,223 )

Proceeds from the sale of property and equipment

     1,076       15,135  

Purchase of minority interest

     (95,153 )     —    

Increase in short-term investments

     (111,709 )     —    

Decrease/(increase) in other assets and other, net

     4,191       (9,620 )
    


 


Net cash used in investing activities

     (532,513 )     (443,708 )
    


 


CASH FLOWS FROM FINANCING ACTIVITIES

                

Repayments of short-term borrowings, net

     (12,222 )     (4,197 )

Net proceeds from issuance of long-term debt

     —         26,587  

Repayments of long-term debt

     (4,250 )     (5,180 )

Changes in bank checks outstanding

     (143,210 )     (135,199 )

Proceeds from minority interests

     1,628       3,005  

Exercise of stock options

     26,085       9,405  
    


 


Net cash used in financing activities

     (131,969 )     (105,579 )
    


 


EFFECT OF EXCHANGE RATE CHANGES ON CASH

     22,296       6,258  
    


 


Net increase in cash and cash equivalents

     630,498       363,484  

CASH AND CASH EQUIVALENTS BEGINNING OF YEAR

     1,545,439       805,518  
    


 


CASH AND CASH EQUIVALENTS END OF PERIOD

   $ 2,175,937     $ 1,169,002  
    


 


SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:

                

Cash paid during the period for:

                

Interest (net of amounts capitalized)

   $ 8,549     $ 10,627  

Income taxes

   $ 159,178     $ 97,044  

 

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

 

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COSTCO WHOLESALE CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share data)

(unaudited)

 

Note (1)—Summary of Significant Accounting Policies

 

Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial reporting and pursuant to the rules and regulations of the Securities and Exchange Commission. While these statements reflect all normal recurring adjustments which are, in the opinion of management, necessary for fair presentation of the results of the interim period, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. For further information, refer to the financial statements and footnotes thereto included in the Company’s annual report filed on Form 10-K for the fiscal year ended August 31, 2003.

 

The condensed 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 primarily operates membership warehouses under the Costco Wholesale name.

 

Costco operates membership warehouse clubs 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 February 15, 2004, Costco operated 430 warehouse clubs: 318 in the United States; 62 in Canada; 15 in the United Kingdom; five in Korea; three in Taiwan; four in Japan; and 23 warehouses in Mexico with a joint venture partner.

 

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.

 

Fiscal Years

 

The Company reports on a 52/53-week fiscal year basis, which ends on the Sunday nearest August 31st. Fiscal year 2004 is a 52-week year, with the first, second and third quarters consisting of 12 weeks each and the fourth quarter, ending August 29, 2004 consisting of 16 weeks. Fiscal year 2003 was also a 52-week year, which ended August 31, 2003.

 

Cash Equivalents

 

The Company considers all highly liquid investments with a maturity date of three months or less at the date of purchase and proceeds due from credit and debit card transactions with settlement terms of less than five days to be cash equivalents. Of the total cash and cash equivalents of $2,175,937 at February 15, 2004 and $1,545,439 at August 31, 2003, credit and debit card receivables were $417,000 and $412,861, respectively.

 

Short-term Investments

 

Short-term investments 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. All short-term investments are classified as available for sale and are recorded at market value using the specific identification method; unrealized gains and losses are reflected in other accumulated comprehensive income or loss.

 

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Table of Contents

COSTCO WHOLESALE CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(dollars in thousands, except per share data)

(unaudited)

 

Note (1)—Summary of Significant Accounting Policies (Continued)

 

Receivables, net

 

Receivables consist primarily of vendor rebates and promotional allowances, receivables from government tax authorities and other miscellaneous amounts due to the Company, and are net of allowance for doubtful accounts of $1,333 at February 15, 2004 and $1,529 at August 31, 2003. Management determines the allowance for doubtful accounts based on known troubled accounts and historical experience applied to an aging of accounts.

 

Vendor Rebates and Allowances

 

Periodic payments from vendors in the form of buy downs, volume or other purchase discounts that are evidenced by signed agreements are reflected in the carrying value of the inventory when earned 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 inventory method, 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. The Company considers in its calculation of the LIFO cost the estimated net realizable value of inventory in those inventory pools where deflation exists and records a write down of inventory where estimated net realizable value is less than LIFO inventory. If all merchandise inventories had been valued using the first-in, first-out (FIFO) method, inventories would have been lower by $19,500 at both February 15, 2004 and August 31, 2003.

 

     February 15,
2004


   August 31,
2003


Merchandise inventories consist of:

             

United States (primarily LIFO)

   $ 2,811,973    $ 2,668,342

Foreign (FIFO)

     830,391      671,086
    

  

Total

   $ 3,642,364    $ 3,339,428
    

  

 

The Company provides for estimated inventory losses between physical inventory counts on the basis of a standard percentage of sales. This provision is adjusted periodically to reflect the actual shrinkage results of the physical inventory counts, which generally occur in the second and fourth quarters of the Company’s fiscal year.

 

Property and Equipment

 

Property and equipment are stated at cost. Depreciation and amortization expenses are computed using the straight-line method for financial reporting purposes. Buildings are generally depreciated over twenty-five to

 

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COSTCO WHOLESALE CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(dollars in thousands, except per share data)

(unaudited)

 

Note (1)—Summary of Significant Accounting Policies (Continued)

 

thirty-five years; equipment and fixtures are depreciated over three to ten years; and leasehold improvements are amortized over the initial term of the lease or estimated asset life, if shorter.

 

Impairment of Long-Lived Assets

 

The Company periodically evaluates the realizability of long-lived assets for impairment when events or changes in circumstances occur, which may indicate the carrying amount of the asset may not be recoverable. The Company evaluates the carrying value of the asset by comparing the estimated future undiscounted cash flows generated from the use of the asset and its eventual disposition with the asset’s reported net book value. In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, the Company recorded a $1,500 pre-tax, non-cash charge in the first half of fiscal 2004, with no charge in the second quarter, reflecting its estimate of impairment relating to real property, as compared to a $2,524 and $4,829 pre-tax, non-cash charge in the second quarter and for the first half of fiscal 2003, respectively, reflecting its estimate of impairment relating to closed warehouses. The charges reflect the difference between the carrying value and fair value, which was based on estimated market valuations for those assets whose carrying value is not currently anticipated to be recoverable through future cash flows.

 

Goodwill

 

Goodwill, net of accumulated amortization, resulting from certain business combinations is included in other assets, and totaled $76,762 at February 15, 2004 and $46,549 at August 31, 2003. This increase is predominantly a result of the acquisition of a 20% equity interest in Costco Wholesale UK Limited from Carrefour Nederland B.V. on October 3, 2003. On September 3, 2001, the Company adopted SFAS No. 142, “Accounting for Goodwill and Other Intangibles,” which specifies that goodwill and some intangible assets will no longer be amortized, but instead will be subject to periodic impairment testing. Accordingly, the Company reviews previously reported goodwill for impairment on an annual basis, or more frequently if circumstances dictate.

 

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 February 15, 2004 and at August 31, 2003 are $83,889 and $216,980 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 to provide for the potential liabilities for workers’ compensation, general liability, property insurance, director and officers’ liability, vehicle liability and employee health care benefits. Liabilities associated with the risks that are retained by the Company are estimated, in part, by considering historical claims experience and 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.

 

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. The

 

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Table of Contents

COSTCO WHOLESALE CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(dollars in thousands, except per share data)

(unaudited)

 

Note (1)—Summary of Significant Accounting Policies (Continued)

 

aggregate amount of foreign exchange contracts outstanding at February 15, 2004 was not material. The only significant derivative instruments the Company holds are interest rate swaps, which the Company uses to manage interest rates associated with its borrowings and to manage the Company’s mix of fixed and variable-rate debt. As of February 15, 2004, the Company had “fixed-to-floating” interest rate swaps with an aggregate notional amount of $600,000 and an aggregate fair value of $38,490, which is recorded in other assets. These swaps were entered into effective November 13, 2001, and March 25, 2002, and are designated and qualify as fair value hedges of the Company’s $300,000 71/8% Senior Notes and the Company’s $300,000 51/2% Senior Notes, respectively. As the terms of the swaps match those of the underlying hedged debt, the changes in the fair value of these swaps are offset by corresponding changes in the carrying amount of the hedged debt, and result in no net earnings impact.

 

Foreign Currency Translations

 

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 other comprehensive income (loss). 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 expenses.

 

Revenue Recognition

 

The Company recognizes sales, net of estimated returns, at the time the member takes possession of merchandise or receives services. When the Company collects payment from customers prior to the transfer of ownership of merchandise or the performance of services, the amount received is recorded as deferred revenue. The Company provides for estimated sales returns based on historical returns levels. The reserve for sales returns (sales returns net of merchandise costs) approximated $5,000 at February 15, 2004 and August 31, 2003.

 

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 the one-year life of the membership. 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 12 weeks and 24 weeks ended February 15, 2004 and February 16, 2003, and the related liability as of those dates were as follows:

 

     12 Weeks Ended

   24 Weeks Ended

     February 15,
2004


   February 16,
2003


   February 15,
2004


   February 16,
2003


Two-percent reward sales reduction

   $ 57,150    $ 39,863    $ 104,745    $ 73,609

Two-percent unredeemed reward liability

   $ 139,838    $ 103,355    $ 139,838    $ 103,355

 

Merchandise Costs

 

Merchandise costs consist of the purchase price of inventory sold, inbound shipping charges and all costs related to our depot operations, including freight from depots to selling warehouses. Merchandise costs also

 

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COSTCO WHOLESALE CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(dollars in thousands, except per share data)

(unaudited)

 

Note (1)—Summary of Significant Accounting Policies (Continued)

 

include salaries, benefits, depreciation on production equipment, and other related expenses incurred 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 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.

 

Stock-Based Compensation

 

The Company adopted the fair value based method of recording stock options consistent with SFAS No. 123 “Accounting for Stock-Based Compensation,” for all employee stock options granted subsequent to fiscal year end 2002. Specifically, the Company adopted SFAS No. 123 using the “prospective method” with guidance provided from SFAS No. 148 “Accounting for Stock-Based Compensation – Transition and Disclosure.” All employee stock option grants made subsequent to fiscal 2002 are to be expensed over the stock option vesting period based on the fair value at the date the options are granted. Prior to fiscal 2003 the Company applied Accounting Principles Board Opinion (APB) No. 25 and related interpretations in accounting for stock options. Because the Company granted stock options to employees at exercise prices equal to fair market value on the date of grant, accordingly, no compensation cost was recognized for option grants in periods prior to fiscal 2003.

 

Had compensation costs for the Company’s stock-based compensation plans been determined based on the fair value at the grant dates for awards made prior to fiscal 2003, under those plans and consistent with SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company’s net income and net income per share would have been reduced to the pro forma amounts indicated below:

 

     12 Weeks Ended

    24 Weeks Ended

 
     February 15,
2004


    February 16,
2003


    February 15,
2004


    February 16,
2003


 

Net income, as reported

   $ 226,792     $ 182,065     $ 386,967     $ 327,794  

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

     3,764       211       7,467       243  

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

     (13,796 )     (17,022 )     (27,963 )     (34,720 )
    


 


 


 


Pro-forma net income

   $ 216,760     $ 165,254     $ 366,471     $ 293,317  
    


 


 


 


Earnings per share:

                                

Basic – as reported

   $ .49     $ .40     $ .85     $ .72  
    


 


 


 


Basic – pro-forma

   $ .47     $ .36     $ .80     $ .64  
    


 


 


 


Diluted – as reported

   $ .48     $ .39     $ .82     $ .70  
    


 


 


 


Diluted – pro-forma

   $ .46     $ .35     $ .77     $ .62  
    


 


 


 


 

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Table of Contents

COSTCO WHOLESALE CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(dollars in thousands, except per share data)

(unaudited)

 

Note (1)—Summary of Significant Accounting Policies (Continued)

 

Closing Costs

 

Warehouse closing costs incurred relate principally to the Company’s efforts to relocate certain warehouses, which were otherwise not impaired, to larger and better-located facilities. As of February 15, 2004, the Company’s reserve for warehouse closing costs was $9,791, which relates almost entirely to lease obligations. This compares to a reserve for warehouse closing costs of $8,609 at August 31, 2003, of which $7,833 related to lease obligations.

 

Interest Income and Other

 

Interest income and other includes:

 

     12 Weeks Ended

   24 Weeks Ended

     February 15,
2004


   February 16,
2003


   February 15,
2004


   February 16,
2003


Interest income

   $ 7,570    $ 4,933    $ 12,048    $ 8,040

Minority interest/earnings of affiliates and other

     5,502      4,050      8,927      8,577
    

  

  

  

Total

   $ 13,072    $ 8,983    $ 20,975    $ 16,617
    

  

  

  

 

Income Taxes

 

The Company accounts for income taxes under the provisions of SFAS No. 109, “Accounting for Income Taxes.” That standard requires companies to account for deferred income taxes using the asset and liability method.

 

Under the asset and liability method of SFAS No. 109, 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.

 

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Table of Contents

COSTCO WHOLESALE CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(dollars in thousands, except per share data)

(unaudited)

 

Note (1)—Summary of Significant Accounting Policies (Continued)

 

Net Income Per Common and Common Equivalent Share

 

The following data show the amounts used in computing earnings per share and the effect on income and the weighted average number of shares of dilutive potential common stock.

 

     12 Weeks Ended

   24 Weeks Ended

     February 15,
2004


   February 16,
2003


   February 15,
2004


   February 16,
2003


Net income available to common stockholders used in basic EPS

   $ 226,792    $ 182,065    $ 386,967    $ 327,794

Interest on convertible bonds, net of tax

     2,638      2,507      5,276      4,974
    

  

  

  

Net income available to common stockholders after assumed conversions of dilutive securities

   $ 229,430    $ 184,572    $ 392,243    $ 332,768
    

  

  

  

Weighted average number of common shares used in basic EPS (000’s)

     458,228      455,927      457,929      455,748

Stock options (000’s)

     3,964      3,292      3,611      3,649

Conversion of convertible bonds (000’s)

     19,345      19,345      19,345      19,345
    

  

  

  

Weighted number of common shares and dilutive potential common stock used in diluted EPS (000’s)

     481,537      478,564      480,885      478,742
    

  

  

  

 

The diluted share base calculation for the fiscal quarters ended February 15, 2004 and February 16, 2003 excludes 28,074,272 and 29,754,347 stock options outstanding, respectively. The diluted share base calculation for the fiscal year-to-date periods ended February 15, 2004 and February 16, 2003, excluded 29,063,073 and 29,803,398 stock options outstanding, respectively. These options are excluded due to their anti-dilutive effect.

 

Recent Accounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities.” In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either does not have equity investors with voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities. Interpretation No. 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of Interpretation No. 46 apply immediately to variable interest entities created after January 31, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. In December 2003, the FASB issued Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities”, (FIN 46R) which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” which was issued in January 2003 and revised the implementation date to the first fiscal year or interim period ending after March 15, 2004, with the exception of special purpose entities. The Company is currently evaluating the potential impact the adoption of this interpretation will have on its consolidated financial statements.

 

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Table of Contents

COSTCO WHOLESALE CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(dollars in thousands, except per share data)

(unaudited)

 

Note (1)—Summary of Significant Accounting Policies (Continued)

 

In November 2002, the Emerging Issues Task Force (EITF) reached consensus on certain issues discussed in EITF 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor,” with respect to determining how a reseller should characterize consideration received from a vendor and when to recognize and how to measure that consideration in its income statement. Requirements for recognizing volume-based rebates are effective for arrangements entered into or modified after November 21, 2002 and resellers with other supplier payments should generally apply the new rules prospectively for agreements entered into or modified after December 31, 2002. The adoption of this consensus will not have a significant impact on the Company on an annual basis. However, the application of the consensus has resulted in a change in the timing for the recognition of some vendor allowances for certain agreements entered into subsequent to December 31, 2002 and will extend the recognition time frame beyond that which was in effect for similar contracts entered into prior to December 31, 2002. Net income for the second quarter of fiscal 2004 was positively impacted by $5,772 after-tax ($.01 per diluted share) and was negatively impacted for the year-to-date period ended February 15, 2004 by $14,593 after-tax ($.03 per diluted share) due to the adoption of EITF 02-16.

 

In November 2003, the EITF reached consensus on EITF 03-10, “Application of Issue No. 02-16 by Resellers to Sales Incentives Offered to Consumers by Manufacturers,” with respect to determining if consideration received by a reseller from a vendor that is reimbursed by the vendor for honoring the vendor’s sale incentives offered directly to consumers should be recorded as a reduction of the cost of the resellers purchases and, therefore, characterized as a reduction in cost of sales. These rules apply to transactions entered into by consumers in fiscal periods beginning after November 25, 2003 and, therefore, will apply to such transactions starting with the Company’s fiscal third quarter of 2004. The adoption of EITF 03-10 will not affect the Company’s consolidated gross profit or net income, but will result in a reduction of both net sales and merchandise costs by an equal amount.

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of 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.

 

Note (2)—Short-term Investments

 

Short-term investments at February 15, 2004 were as follows:

 

     Cost Basis

   Unrealized
Gains


   Unrealized
Losses


    Recorded
Basis


U.S. government and agency securities

   $ 46,017    $ 398    $     $ 46,415

Money market mutual funds

     11,347                 11,347

Corporate notes and bonds

     38,271      430            38,701

Asset backed securities

     13,114      64      (4 )     13,174

Mortgage backed securities

     2,057      15            2,072
    

  

  


 

Total short-term investments

   $ 110,806    $ 907    $ (4 )   $ 111,709
    

  

  


 

 

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Table of Contents

COSTCO WHOLESALE CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(dollars in thousands, except per share data)

(unaudited)

 

Note (3)—Comprehensive Income

 

Comprehensive income is net income, plus certain other items that are recorded directly to shareholders’ equity. Comprehensive income was $275,183 and $208,291 for the second quarters of fiscal 2004 and 2003, respectively and $511,771 and $340,554 for the first half of fiscal 2004 and 2003, respectively. Foreign currency translation adjustments and unrealized gains and losses on short-term investments are applied to net income to calculate the Company’s comprehensive income, with the predominant component being the foreign currency translation adjustment.

 

Note (4)—Stock-based Compensation

 

The Company recognized stock compensation costs of $5,975 and $11,853, respectively, in the second quarter of fiscal 2004 and the first half of fiscal 2004, versus stock compensation costs of $343 and $395, respectively, in the second quarter of fiscal 2003 and the first half of fiscal 2003.

 

Additional stock compensation costs that would have been recorded had SFAS No. 123 been adopted as of its initial effective date would have totaled $15,924 and $32,533 (pre-tax) in the second quarter and first half of fiscal 2004, respectively, and $27,678 and $56,456 (pre-tax) in the second quarter and first half of fiscal 2003.

 

Note (5)—Debt

 

Bank Credit Facilities and Commercial Paper Programs

 

The Company has in place a $500,000 commercial paper program supported by a $300,000 bank credit facility with a group of ten banks, of which $150,000 expires on November 9, 2004, and $150,000 expires on November 15, 2005. At February 15, 2004, no amounts were outstanding under the commercial paper program or the credit facility. Covenants related to the credit facility place limitations on total Company indebtedness. At February 15, 2004, the Company was in compliance with all covenants.

 

In addition, a wholly-owned Canadian subsidiary has a $152,000 commercial paper program supported by a $45,700 bank credit facility with a Canadian bank, which expires in March 2005. At February 15, 2004, no amounts were outstanding under the Canadian commercial paper program or the bank credit facility.

 

The Company has agreed to limit the combined amount outstanding under the U.S. and Canadian commercial paper programs to the $345,700 combined amounts of the respective supporting bank credit facilities.

 

The Company’s wholly-owned Japanese subsidiary has a short-term $28,500 bank line of credit, which expires in November 2004. At February 15, 2004, no amounts were outstanding under the line of credit.

 

The Company’s wholly-owned UK subsidiary has a $113,800 bank revolving credit facility and a $47,400 bank overdraft facility, both expiring in February 2007. At February 15, 2004, $43,615 was outstanding under the revolving credit facility and no balance was outstanding under the bank overdraft facility.

 

Letters of Credit

 

The Company has separate letter of credit facilities (for commercial and standby letters of credit), totaling approximately $374,000. The outstanding commitments under these facilities at February 15, 2004 totaled approximately $114,300, including approximately $46,000 in standby letters of credit.

 

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Table of Contents

COSTCO WHOLESALE CORPORATION

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(dollars in thousands, except per share data)

(unaudited)

 

Note (6)—Commitments And Contingencies

 

Legal Proceedings

 

The Company is involved from time to time in claims, proceedings and litigation arising from its business and property ownership. The Company is a defendant in two actions purportedly brought as class actions on behalf of certain present and former Costco managers in California, in which plaintiffs allege that they have not been properly compensated for overtime work. Presently, claims are made under various provisions of the California Labor Code and the California Business and Professions Code. Plaintiffs seek restitution/disgorgement, compensatory damages, various statutory penalties, liquidated damages, punitive, treble and exemplary damages, and attorneys’ fees. In neither case has the Court been asked yet to determine whether the action should proceed as a class action or, if so, the definition of the class. The Company expects to vigorously defend these actions. The Company does not believe that any claim, proceeding or litigation, either alone or in the aggregate, will have a material adverse effect on the Company’s consolidated financial position or results of operations.

 

Note (7)—Segment Reporting

 

The Company and its subsidiaries are principally engaged in the operation of membership warehouses in the United States, Canada, Japan, the United Kingdom and through majority-owned subsidiaries in Taiwan and Korea and through a 50%-owned joint venture in Mexico. The Company’s reportable segments are based on management responsibility and exclude the Mexico joint-venture, as it is accounted for under the equity method and, therefore, its operations are not consolidated in the Company’s financial statements.

 

    

United States

Operations


  

Canadian

Operations


  

Other

International
Operations


   Total

Twenty-Four Weeks Ended February 15, 2004

                           

Total revenue

   $ 18,001,049    $ 2,845,373    $ 1,224,030    $ 22,070,452

Operating income

     478,595      104,268      27,131      609,994

Depreciation and amortization

     164,209      19,140      16,464      199,813

Capital expenditures

     276,709      47,341      6,868      330,918

Long lived assets

     5,806,196      678,461      718,231      7,202,888

Total assets

     11,333,495      1,653,104      1,290,869      14,277,468

Net assets

     5,421,562      869,980      820,249      7,111,791

Twenty-Four Weeks Ended February 16, 2003

                           

Total revenue

   $ 16,001,642    $ 2,312,279    $ 998,831    $ 19,312,752

Operating income

     422,075      95,057      15,720      532,852

Depreciation and amortization

     145,003      14,592      15,415      175,010

Capital expenditures

     389,606      35,365      24,252      449,223

Long lived assets

     5,614,135      549,621      643,484      6,807,240

Total assets

     9,999,746      1,293,355      1,049,742      12,342,843

Net assets

     4,812,598      632,788      603,756      6,049,142

Year Ended August 31, 2003

                           

Total revenue

   $ 35,119,039    $ 5,237,023    $ 2,189,490    $ 42,545,552

Operating income

     927,590      199,043      29,995      1,156,628

Depreciation and amortization

     323,850      33,732      33,720      391,302

Capital expenditures

     698,713      68,432      43,520      810,665

Long lived assets

     5,705,675      612,647      641,686      6,960,008

Total assets

     10,522,260      1,579,972      1,089,456      13,191,688

Net assets

     5,141,056      783,521      630,403      6,554,980

 

The accounting policies of the segments are the same as those described in Note 1. All inter-segment net sales and expenses are immaterial and have been eliminated in computing total revenue and operating income.

 

26