ITEM 1 -- BUSINESS
DESCRIPTION OF THE MERGER
On October 21, 1993, the shareholders of both The Price Company ("Price") and Costco Wholesale Corporation ("Costco") approved the mergers of Price and Costco with and into separate, wholly owned subsidiaries of Price/Costco, Inc. ("PriceCostco" or the "Company"). The mergers are hereinafter called the "Merger." PriceCostco was formed to effect the Merger. Pursuant to the Merger, Price and Costco each became a wholly owned subsidiary of PriceCostco. In the Merger, shareholders of Price received 2.13 shares of PriceCostco common stock for each share of Price common stock and shareholders of Costco received one share of PriceCostco common stock for each share of Costco common stock.
The Merger qualified as a "pooling-of-interests" for accounting and financial reporting purposes. The pooling-of-interests method of accounting presents as a single interest two or more common shareholder interests which were previously independent. The pooling-of-interests method of accounting treats the combining companies as if they had been a single business entity from inception. Consequently, the historical financial statements for periods prior to the consummation of the Merger have been restated as though the companies had been combined. The financial statements have also been adjusted to conform the accounting policies and interim reporting periods of the separate companies.
The fees and expenses related to the Merger and to the consolidation and restructuring of the combining companies (approximately $120 million, or $80 million after tax) were expensed as required under the pooling-of-interests accounting method and were reflected in the consolidated statement of income of PriceCostco in the first quarter of fiscal 1994, the period in which the Merger occurred. Such fees and expenses include direct transaction costs, expenses related to consolidating and restructuring certain functions, costs of the closing of certain excess facilities and sales of related properties, costs of severance and relocation and write-offs of certain redundant capitalized costs and other assets (See "Notes to Consolidated Financial Statements -- Note 2 -- Merger of Price and Costco" for an analysis of the provision for merger and restructuring).
GENERAL
PriceCostco operates cash and carry 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 rapid inventory turnover and high sales volumes. 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 PriceCostco to operate profitably at significantly lower gross margins than traditional wholesalers, discount retailers and supermarkets.
PriceCostco buys virtually all of its merchandise directly from manufacturers for shipment either directly to PriceCostco's selling warehouses or to a consolidation point where various shipments are combined so as to minimize freight and handling costs. As a result, PriceCostco eliminates 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. By providing this more cost effective means of distributing goods, PriceCostco meets the needs of business customers who otherwise would pay a premium for small purchases and for the distribution services of traditional wholesalers, and who cannot otherwise obtain the full range of their product requirements from any single source. In addition, these business members will often combine personal shopping with their business purchases. Individuals shopping for their personal needs are primarily motivated by the cost savings on brand name merchandise. PriceCostco's merchandise selection is designed to appeal to both the business and consumer requirements of its members by offering a wide range of nationally branded and selected private label products, often in case, carton or multiple-pack quantities, at attractively low prices.
Because of its high sales volume and rapid inventory turnover, PriceCostco generally has the opportunity to receive cash from the sale of a substantial portion of its inventory at mature warehouse operations before it is required to pay all its merchandise vendors, even though PriceCostco takes advantage of early payment terms to obtain payment discounts. As sales in a given warehouse increase and inventory turnover becomes more rapid, a greater percentage of the inventory is financed through payment terms provided by vendors rather than by working capital.
PriceCostco's typical warehouse format averages approximately 120,000 square feet. Floor plans are designed for economy and efficiency in the use of selling space, in the handling of merchandise and in the control of inventory. Because shoppers are attracted principally by the availability of low prices on brand name and selected private label goods, PriceCostco's warehouses need not be located on prime commercial real estate sites or have elaborate facilities.
By strictly controlling the entrances and exits of its warehouses and by limiting membership to selected groups and businesses, PriceCostco has been able to limit inventory losses to less than one-half of one percent of net sales, well below those of typical discount retail operations. Problems associated with dishonored checks have also been insignificant, since individual memberships are limited primarily to members of qualifying groups, and bank information from business members is verified prior to establishing a check purchase limit. Memberships are invalidated at the point of sale for those members who have issued dishonored checks to PriceCostco.
PriceCostco's policy is generally to limit advertising and promotional expenses to new warehouse openings and occasional direct mail advertisements to prospective new members. These practices result in very low marketing expenses as compared to typical discount retailers and supermarkets. In connection with new warehouse openings, PriceCostco's marketing teams personally contact businesses in the area who are potential wholesale members. These contacts are supported by direct mailings during the period immediately prior to opening. Potential Gold Star (individual) members are contacted by direct mail generally distributed through credit unions, employee associations and other entities representing the individuals who are eligible for Gold Star membership. After a membership base is established in an area, most new memberships result from word of mouth advertising, follow-up contact by direct mail distributed through regular payroll or other organizational communications to employee groups, and ongoing direct solicitations of prospective wholesale members.
PriceCostco's warehouses generally operate on a seven-day, 68-hour week, and are open somewhat longer during the holiday season. Generally, warehouses are open weekdays between 10:00 a.m. and 8:30 p.m. Because these hours of operation are shorter than those of the traditional discount or grocery retailer, 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. In addition, sales are processed through an efficient centralized check-out facility. Items are not individually price marked, but are keyed or scanned into PriceCostco's electronic cash registers by an identifying item number, thereby allowing price changes without remarking merchandise. Substantially all manufacturers provide special, larger package sizes and merchandise pre-marked with the item numbers.
PriceCostco's merchandising strategy is to provide the customer with a broad range of high quality merchandise at prices consistently lower than could be obtained through traditional wholesalers, discount retailers or supermarkets. An important element of this strategy is to carry only those products on which PriceCostco can provide its members significant cost savings. Consequently, items which members may request but which cannot be purchased at prices sufficiently low enough to pass along meaningful cost savings to members are often not carried. PriceCostco seeks to limit specific items in each product line to fast selling models, sizes and colors and therefore carries only an average of approximately 3,500 to 4,000 active stockkeeping units ("SKU's") per warehouse as opposed to full-line discount retailers which normally stock 40,000 to 60,000 SKU's or more. These practices are consistent with PriceCostco's membership policies of satisfying both the business and personal shopping needs of its wholesale members, thereby encouraging high volume shopping. Many consumable
products are offered for sale in case, carton or multiple-pack quantities only. Appliances, equipment and tools often feature commercial and professional models. PriceCostco's policy is to accept returns of merchandise within a reasonable time after purchase.
The following table indicates the approximate percentage of sales accounted for by each major category of items sold by PriceCostco during fiscal 1994, 1993 and 1992:
PriceCostco has direct buying relationships with many producers of national brand name merchandise. No significant portion of merchandise is obtained by PriceCostco from any one of these or other suppliers. PriceCostco has not experienced any difficulty in obtaining sufficient quantities of merchandise, and believes that if one or more of its current sources of supply became unavailable, it would be able to obtain alternative sources without experiencing a substantial disruption of its business. Also, PriceCostco purchases on a competitive cost basis, stocking different national brand name or selected private label merchandise of the same product, as long as quality and customer demand are comparable.
PriceCostco is incorporated in the State of Delaware, and reports on a 52/53 week fiscal year, consisting of 13 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 PriceCostco's operations, except an increased level of sales and earnings during the Christmas holiday season.
MEMBERSHIP POLICY
PriceCostco's membership format is designed to reinforce customer loyalty and also to provide a continuing source of membership fee revenue. PriceCostco has two primary types of members: Business and Gold Star (individual members).
Businesses, including individuals with a business license, retail sales license or other evidence of business existence, may become Business members. PriceCostco promotes Business membership through its merchandise selection and its membership marketing programs. Business members generally pay an annual membership fee of $35 for the primary membership card with additional membership cards available for an annual fee of from $10 to $15.
Individual memberships are available to employees of federal, state and local governments, financial institutions, corporations, utility and transportation companies, public and private educational institutions, and other selected organizations. Individual members generally pay an annual membership fee of $35 which includes a second membership card.
As of August 28, 1994, PriceCostco had approximately 3.4 million Business memberships and approximately 6.4 million Gold Star memberships. Members can utilize their memberships at any Price Club or Costco Wholesale location.
LABOR
As of August 28, 1994, PriceCostco had approximately 47,000 employees, about 50% of which were part time. Substantially all of Price's hourly employees in California, Connecticut, Maryland, Massachusetts, New Jersey, New York and one Price Club warehouse in Virginia are represented by the International Brotherhood of Teamsters. Nearly all other employees are non-union. PriceCostco considers its employee relations to be good.
COMPETITION
The Company operates in the rapidly changing and highly competitive merchandising industry. When Price pioneered the membership warehouse club concept in 1976, the dominant companies selling comparable lines of merchandise were department stores, grocery stores and traditional wholesalers. Since then, new merchandising concepts and aggressive marketing techniques have led to a more intense and focused competitive environment. Wal-Mart and Kmart have become the largest retailers in the United States and have recently expanded into food merchandising. Target has also emerged as a significant retail competitor. Approximately 800 warehouse clubs exist across the U.S. and Canada, including the 221 warehouses operated by the Company, and every major metropolitan area has some, if not several, club operations. Low cost operators selling a single category or narrow range of merchandise, such as Home Depot, Office Depot, Petsmart, Toys-R-Us, Circuit City and Barnes & Noble Books, have gained major market share in their respective categories. New forms of retailing involving modern technology are boosting sales in stores such as The Sharper Image, while home shopping is becoming increasingly popular. Likewise, in the food business, a competitor like Smart & Final, which operates in Arizona and California, is capturing an increasingly greater share of the institutional food business from wholesale operators and others; and many supermarkets now offer food lines in bulk sizes and at prices comparable to those offered by the Company. This factor, among others, has caused comparable warehouse sales to decline during fiscal 1994 resulting in lower average sales and earnings per location (see "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations").
REGULATION
Certain state laws require that the Company apply minimum markups to its selling prices for specific goods, such as tobacco products and alcoholic beverages, and prohibit the sale of specific goods, such as tobacco and alcoholic beverages, at different prices in one location. While compliance with such laws may cause the Company to charge somewhat higher prices than it otherwise would charge, other mass merchandisers are also typically governed by the same restrictions, and the Company believes that compliance with such laws does not have a material adverse effect on its operations.
It is the policy of the Company 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 the Company or to other purchasers that do not adhere to suggested retail prices. To date, the Company believes that it has not been materially affected by its inability to purchase directly from such manufacturers. Both federal and state legislation is proposed from time to time which, if enacted, would restrict the Company's ability to purchase goods or extend the application of laws enabling the establishment of minimum prices. The Company cannot predict the effect on its business of the enactment of such federal or state legislation.
DESCRIPTION OF THE EXCHANGE TRANSACTION
On July 28, 1994, PriceCostco entered into an Agreement of Transfer and Plan of Exchange (as amended and restated, the "Transfer and Exchange Agreement") with Price Enterprises, Inc., ("Price Enterprises"). Price Enterprises is a Delaware corporation and an indirect, wholly owned subsidiary of the Company. The transactions contemplated by the Transfer and Exchange Agreement are hereinafter referred to as the "Exchange Transaction."
Pursuant to the Transfer and Exchange Agreement and upon the terms and subject to the conditions set forth in an Offering Circular/Prospectus and related Letter of Transmittal (which will be mailed to stock holders of record of the Company's common stock), the Company will offer to
exchange one share of common stock of Price Enterprises for each share of common stock of the Company, up to a maximum of 27 million shares of Price Enterprises common stock (constituting all of the outstanding shares of Price Enterprises common stock) (the "Exchange Offer"). The Company currently anticipates that the Exchange Offer will be commenced prior to the end of November 1994. In connection therewith, the Offering Circular/Prospectus and the Letter of Transmittal, which will describe the Exchange Transaction in detail, will be mailed to such holders. If more than 27 million shares of the Company's common stock are validly tendered and not withdrawn in the Exchange Offer prior to the expiration thereof, then, upon the terms and subject to the conditions set forth in such Offering Circular/Prospectus and such related Letter of Transmittal, the Company will accept 27 million shares for exchange on a pro rata basis, and shares of Price Enterprises common stock will be exchanged therefor.
If the number of shares of the Company's common stock validly tendered in the Exchange Offer by holders of the Company's common stock is less than 21.6 million, the Company will accept such validly tendered shares for exchange and will distribute the remaining shares of Price Enterprises common stock pro rata to the Company's stockholders. If the number of shares of the Company's common stock validly tendered in the Exchange Offer is greater than 21.6 million, but less than 27 million, the Company will accept such validly tendered shares for exchange and will, at its option, either (i) distribute the remaining shares of Price Enterprises common stock pro rata to the Company's stockholders or (ii) sell such remaining shares to Price Enterprises in exchange for a promissory note.
Pursuant to the Transfer and Exchange Agreement, as of August 28, 1994, the Company caused to be transferred, or, in certain cases, will cause to be transferred, to Price Enterprises certain assets, including the following:
(a) certain commercial real estate specified in the Transfer and Exchange Agreement that was not integral to the Company's merchandising operations (the "Commercial Properties");
(b) real estate comprising four of the Company's warehouse club facilities (which are adjacent to existing Commercial Properties) that are being leased back to the Company effective August 29, 1994 at collective annual rentals of approximately $8.6 million;
(c) commercial real estate known as 4455 and 4649 Morena Boulevard, San Diego, California;
(d) 51% of the outstanding capital stock of each of Price Global and Price Quest (as defined and described below);
(e) a note in the principal amount of $41 million made by Atlas Hotels, Inc., secured by hotel and convention center property in San Diego, California ("Atlas Note"); and
(f) notes receivable with an aggregate book value of approximately $32 million, which were originally made and delivered by various governmental agencies in connection with the financing and development of certain warehouse club and adjacent real estate sites.
The Company and Price Enterprises have caused to be formed a limited liability company, Mexico Clubs, L.L.C. ("Mexico Clubs") of which the Company and Price Enterprises own 49% and 51% interests, respectively. The Company has caused to be formed two corporations, Price Global Trading, Inc. ("Price Global") and Price Quest, Inc. ("Price Quest" which, together with Mexico Clubs comprise the "Subsidiary Corporations". The Company has caused to be transferred and delivered to:
(a) Mexico Clubs: (i) all shares of capital stock of Price Venture Mexico owned, directly or indirectly, by the Company; (ii) all other noncurrent assets of the Company and its subsidiaries specifically related to the conduct of business in Mexico; and (iii) certain other assets (collectively, the "Mexico Assets"); provided, however, that the term "Mexico Assets" does not include (A) the
Agreement between Price, Price Venture Mexico and Controladora Comercial Mexicana, S.A. de C.V. to form a Corporate Joint Venture dated June 21, 1991, (B) any right, title or interest in or to the names "Price Club," "Price Club Costco" or "PriceCostco" and (C) any computer software.
(b) Price Global: (i) the right to develop a Club Business in certain international areas specified in the Transfer and Exchange Agreement (the "Specified Geographical Areas"); (ii) all shares of capital stock of Club Merchandising, Inc. owned, directly or indirectly, by the Company; (iii) all right, title and interest to, or, in certain cases, a long-term license to use, the names "Price Club," "Price Club Costco" and "Price Costco" in each of the Specified Geographical Areas (other than Mexico); and (iv) all other noncurrent assets of the Company and its subsidiaries (other than those included in Club Merchandising, Inc.) specifically related to the conduct of business in the Specified Geographical Areas (collectively, the "International Assets"); and
(c) Price Quest: (i) all of the noncurrent assets of the Company or any of its subsidiaries specifically related to the business and operations then conducted by the Company through its Quest interactive electronic shopping business, together with Price Club Travel, Price Club Realty and the Price Club automobile advertising/referral business; (ii) all right, title and interest, if any, of the Company or any of its subsidiaries to, or, in certain cases, a long-term license to use, the names "Price Club Quest" and "Quest"; and (iii) certain other assets (collectively, the "Quest Assets").
As used herein, the term "Club Business" refers to any merchandising activity utilizing 70,000 square feet or more in a single location operating with membership and selling food and non-food items through a central check-out.
Each of Price Global and Price Quest issued 100 shares of its common stock to Price, which constitutes all of the outstanding capital stock of each such Subsidiary Corporation. As of August 28, 1994, the Company caused to be transferred to Price Enterprises 51 shares of common stock of each of Price Global and Price Quest, representing 51% of the outstanding capital stock of each such Subsidiary Corporation.
As part of the Exchange Transaction, the Company and Price, on the one hand, and Price Enterprises and each of the Subsidiary Corporations, on the other, have entered into Operating Agreements to clarify the ongoing business relationship between the Company and the respective Subsidiary Corporations. The Company and Price, on the one hand, have also entered into Stockholders Agreements with Price Enterprises and each of Price Global and Price Quest, on the other, to clarify certain rights and obligations of the Company and Price Enterprises as stockholders of Price Global and Price Quest.
Price and Price Enterprises have entered into a Limited Liability Company Agreement with respect to Mexico Clubs which sets forth the rights and obligations of each of Price and Price Enterprises with respect to its membership interest in Mexico Clubs.
Also in connection with the Exchange Transaction, the Company and Price Enterprises entered into an unsecured revolving credit agreement, dated as of August 28, 1994 (the "Advance Agreement"), pursuant to which the Company has agreed to advance to Price Enterprises up to a maximum principal amount of $85 million (reduced by an amount equal to the net proceeds from the sale of any of the Commercial Properties between August 28, 1994 and the date of the closing of the Exchange Transaction (the "Closing Date")) from time to time during the period from August 28, 1994 until six months following the earlier of (A) the Closing Date and (B) the date on which Price Enterprises stock is distributed to stockholders of the Company. The interest rate under the Advance Agreement is the weighted average commercial paper rate on borrowings by the Company during each four-week period (including, without limitation, amortization of lender commitment fees and other costs associated with the backup line of credit and all miscellaneous costs and fees), or if commercial paper is unavailable under the Company's commercial paper program, the bank rate on borrowings by the Company pursuant to its working capital credit facility (including, without limitation, amortization of lender commitment fees and other costs associated with such credit facility and all miscellaneous costs and fees).
Pursuant to the Transfer and Exchange Agreement, upon the earlier to occur of the Closing Date and the date that shares of Price Enterprises common stock are distributed to holders of the Company's common stock, the Bylaws of the Company will be amended to delete the corporate governance provisions that were enacted as part of the Merger to require that the Board of Directors of the Company and certain committees of the Board be comprised of an equal number of Price Designees and Costco Designees (as such terms are hereinafter defined). The form of such Bylaws, as amended, is filed as an Exhibit to this Annual Report on Form 10-K. In addition, at the Closing Date, without any further action on behalf of the Company or Price Enterprises, the resignations of all of the Price Designees from the Board of Directors of the Company, other than Richard M. Libenson and Duane Nelles (which resignations were submitted to the Board of Directors of the Company on July 28, 1994), will become effective. Pursuant to the Transfer and Exchange Agreement, unless removed for cause, each of Messrs. Libenson and Nelles shall serve on the Board of Directors of the Company until the earlier of (i) the date two years following the Closing Date and (ii) such time as Sol Price and Robert Price and their affiliates in the aggregate cease to beneficially own at least two million shares of PriceCostco Common Stock (including any such shares owned by charitable trusts established by either of them).
As used in the Bylaws of the Company, "Price Designees" means those persons specified by Price as initial members of the Board of Directors of the Company as of the effective time of the Merger, or their direct or indirect replacements. The current Price Designees are J. Paul Kinloch, Richard M. Libenson, Mitchell G. Lynn, Duane Nelles (who was elected to the Board on July 28, 1994 following the resignation of Joseph K. Kornwasser), Paul A. Peterson and Robert E. Price. As used in the Bylaws of the Company, "Costco Designees" means those persons specified by Costco as initial members of the Board of Directors of the Company as of the effective time of the Merger, or their direct or indirect replacements. The current Costco Designees are Jeffrey H. Brotman, Daniel Bernard, Richard D. DiCerchio, Hamilton E. James, John W. Meisenbach and James D. Sinegal.
FUTURE OPERATIONS Expansion plans for the United States and Canada during fiscal 1995 are to open 30-35 new warehouse clubs. The Company also expects to continue expansion of its international operations. The Company opened two warehouses in the United Kingdom through a 60%-owned subsidiary, with a third location due to open in June 1995. In October 1994, under a licensing agreement with PriceCostco, a Price Club opened in Seoul, Korea. Other markets are being assessed, particularly in the Pacific Rim. As a result of the Exchange Transaction, the Company's 50% ownership interest in the Mexican joint venture was transferred to Mexico Clubs in which the Company owns a 49% interest. See "Part I -- Business - -- Description of the Exchange Transaction." As of August 28, 1994, there were 8 Price Clubs operating in Mexico through such joint venture. As of October 31, 1994, there were 10 Price Clubs operating in Mexico through such joint venture with one more scheduled to open prior to December 31, 1994.
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 $600 million to $700 million during fiscal 1995: for real estate, building and equipment for warehouse clubs and related operations (including remodels and expansions) in the United States and Canada; for international expansion, including additional investment in the United Kingdom and other potential ventures; and for activities such as business delivery and ancillary business operations.
While the availability of capital resources cannot be predicted with certainty and is dependent upon a number of factors, including factors outside of the Company's control, management believes that the Company's earnings, cash flow, and financing capacity should be adequate to fund ongoing operations, proposed expansion and other planned development efforts.
As a result of the Exchange Transaction, the Company will own a 49% interest in each of the Mexico Assets, the International Assets and the Quest Assets. See "Description of the Exchange Transaction" above.
ITEM 2
ITEM 2 -- PROPERTIES
WAREHOUSE PROPERTIES
At August 28, 1994, PriceCostco operated warehouse clubs in 21 states, 7 Canadian provinces and the United Kingdom under the "Price Club" and "Costco Wholesale" names. The following is a summary of owned and leased warehouses by state and province:
NUMBER OF WAREHOUSES
The following schedule shows warehouse openings (net of warehouse closings) by region for the past five fiscal years and expected openings (net of closings) through December 31, 1994:
The Company's home offices and headquarters are located in Kirkland, Washington and San Diego, California. Following consumation of the Exchange Transaction, the Company will no longer maintain a home office and headquarters in San Diego, California. Additionally, the Company maintains regional buying and administrative offices, operates regional cross-docking facilities for the consolidation and distribution of certain shipments to the warehouses and operates various processing and packaging facilities to support ancillary businesses.
DISCONTINUED OPERATIONS -- NON-CLUB REAL ESTATE SEGMENT
As a result of the Exchange Transaction, the Company's business consists primarily of its warehouse club operations in the United States, Canada and the United Kingdom, and the Company has ceased to have any significant real estate activities that are not directly related to its warehouse club business.
ITEM 3
ITEM 3 -- LEGAL PROCEEDINGS
On April 6, 1992, Price was served with a complaint in an action entitled FECHT ET AL. V. THE PRICE COMPANY ET AL., Case No. 92-497, United States District Court, Southern District of California (the "Court"). Subsequently, on April 22, 1992, Price was served with a first amended complaint in the action. The case was dismissed without prejudice by the Court on September 21, 1992, on the grounds the plaintiffs had failed to state a sufficient claim against defendants.
Subsequently, plaintiffs filed a Second Amended Complaint which, in the opinion of the Company's counsel, alleged substantially the same facts as the prior complaint. The case was dismissed with prejudice by the Court on March 9, 1993, on grounds the plaintiffs had failed to state a sufficient claim against defendants. Plaintiffs have filed an Appeal in the Ninth Circuit Court of Appeals, which was argued on October 4, 1994. The Company is currently awaiting a Ninth Circuit Court of Appeals decision. If the Ninth Circuit Court of Appeals renders a decision that is adverse to the Company, the Company will continue its vigorous defense of the suit. The Company does not believe that the ultimate outcome of such litigation will have a material adverse effect on the Company's financial position or results of operations.
The Company is involved from time to time in claims, proceedings and litigation arising from its business and property ownership. The Company does not believe that any such claim, proceeding or litigation, either alone or in the aggregate, will have a material adverse effect on the Company's financial position or results of operations.
ITEM 4
ITEM 4 -- SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company's annual meeting is scheduled for 10:00 a.m. on January 27, 1995 at the Bellevue Inn in Bellevue, Washington. Matters to be voted on will be included in the Company's proxy statement to be filed with the Securities and Exchange Commission and distributed to stockholders prior to the meeting.
ITEM 4A -- EXECUTIVE OFFICERS OF THE REGISTRANT
The following is a list of the names, ages and positions of the executive officers of the registrant.
Robert E. Price has been the Chairman of the Board of PriceCostco since the Merger, although he has tendered his resignation effective as of the earlier of (i) the Closing Date and (ii) the date on which shares of Price Enterprises common stock are distributed to stockholders of PriceCostco (see "Description of the Exchange Transaction"). He was Chief Executive Officer and a director of Price since 1976, and was Chairman of the Board of Price since January 1989. Mr. Price was President of Price from 1976 until December 1990.
James D. Sinegal has been the President, Chief Executive Officer and a director of PriceCostco since the Merger. He was President and Chief Operating Officer of Costco since its inception and was elected Chief Executive Officer in August 1988. Mr. Sinegal is a co-founder of Costco and a director of Price Enterprises.
Jeffrey H. Brotman is a native of the Pacific Northwest and is a 1967 graduate of the University of Washington Law School. Mr. Brotman has been the Vice Chairman of the Board of PriceCostco since the Merger. He is a founder of Costco and a number of other specialty retail chains. Mr. Brotman is a director of Seafirst Bank; Carrefour, U.S.; Starbucks Corp.; The Sweet Factory and Garden Botanika.
Mitchell G. Lynn served as Senior Executive Vice President of PriceCostco from the Merger until mid July 1994 and has been a director of PriceCostco since the Merger, although he has tendered his resignation effective as of the earlier of (i) the Closing Date and (ii) the date on which shares of Price Enterprises common stock are distributed to stockholders of PriceCostco (see "Description of the
Exchange Transaction"). He has been President of Price since December 1990 and a director of Price since January 1991, although he has tendered his resignation as an officer and director of Price effective as of the earlier of (i) the Closing Date and (ii) the date on which shares of Price Enterprises common stock are distributed to stockholders of PriceCostco. Mr. Lynn joined Price as Controller in September 1979 and became a Vice President in 1984. From August 1989 to December 1990 Mr. Lynn was an Executive Vice President of Price and President of Price Club Industries, a division of Price.
Richard D. DiCerchio has been Executive Vice President -- Merchandising, Distribution, Construction and Marketing of PriceCostco since the Merger and, until mid August 1994 also served as Executive Vice President, Chief Operating Officer -- Northern Division. He was elected Chief Operating Officer -- Western Region of Costco in August 1992 and was elected Executive Vice President and Director of Costco in April 1986. From June 1985 to April 1986, he was Senior Vice President, Merchandising of Costco. He joined Costco as Vice President, Operations in May 1983.
Richard A. Galanti has been Executive Vice President and Chief Financial Officer of PriceCostco since the Merger. He was Senior Vice President, Chief Financial Officer and Treasurer of Costco since January 1985, having joined Costco as Vice President -- Finance in March 1985. From 1978 to February 1984, Mr. Galanti was an Associate with Donaldson, Lufkin & Jenrette Securities Corporation.
Franz E. Lazarus has been Executive Vice President, Chief Operating Officer - -- Northern Division of PriceCostco since August 1994 and had previously served as Executive Vice President, Chief Operating Officer -- Eastern Division since the Merger. He was named Executive Vice President, Chief Operating Officer -- East Coast Operations of Costco in August 1992. Mr. Lazarus joined Costco in November 1983 and has held various positions prior to his current position.
David B. Loge has been an Executive Vice President -- PriceCostco Industries since August 1994. Mr. Loge joined Price as a Director of Price Club Industries in March 1989 and became Vice President of Price and President of Price Club Industries in December 1990. Prior to joining Price, he served as Vice President of Operations of Sundale Beverage in Belmont, California.
Edward B. Maron has been Executive Vice President, Chief Operating Officer - -- Canadian Division of PriceCostco since the Merger. He had been Senior Vice President, Canadian Division of Costco since April 1990. He previously held various management positions since joining Costco in June 1985.
Joseph P. Portera has been Executive Vice President, Chief Operating Officer - -- Eastern Division of Price Costco since August, 1994. He was Senior Vice President-Operations, Northern California Region from October, 1993 to August 1994. From August 1991 to October 1993 he was Senior Vice President Merchandising -- Non Foods of Costco, and held various management positions since joining Costco in April 1984.
Steven A. Velazquez was Executive Vice President -- Quest of PriceCostco from the Merger through early November 1994, overseeing the development of the Quest business. He is currently an Executive Vice President of Price Enterprises. He joined Price as a buyer in July 1981, became Vice President in February 1989, and became Executive Vice President of Merchandising in April 1990. Prior to joining Price, Mr. Velazquez was a buyer for Safeway Stores, San Diego Division.
Theodore Wallace was Executive Vice President -- International of PriceCostco from the Merger through early November 1994, overseeing international expansion into the Pacific rim and other markets. He is currently an Executive Vice President of Price Enterprises. Mr. Wallace became an Executive Vice President of Price in 1984 and, from 1988 until Fall 1992, he was Chief Operating Officer (East Coast) of Price. He was a director of Price from October 1988 to October 1993. He joined Price as a warehouse manager in September 1977 and was its Vice President of Operations from 1983 to 1988.
Dennis R. Zook has been Executive Vice President, Chief Operating Officer -- Southern Division of PriceCostco since the Merger. He was Executive Vice President of Price since February 1989. Mr. Zook became Vice President of West Coast Operations of Price in October 1988. He joined Price as a warehouse manager in October 1982.
PART II
ITEM 5
ITEM 5 -- MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
In the Merger, which occurred on October 21, 1993, each share of common stock, par value $.10 per share, of Price ("Price Common Stock") was exchanged for 2.13 shares of PriceCostco Common Stock and each share of common stock, par value $.0033 per share, of Costco ("Costco Common Stock") was exchanged for one share of PriceCostco Common Stock.
Prior to October 21, 1993, Price Common Stock was quoted on The Nasdaq Stock Market's National Market under the symbol "PCLB" and Costco Common Stock was quoted on The Nasdaq Stock Market's National Market under the symbol "COST." Trading in PriceCostco Common Stock commenced on October 22, 1993. PriceCostco Common Stock is quoted on The Nasdaq Stock Market's National Market under the symbol "PCCW."
The following table sets forth the high and low sales prices of PriceCostco Common Stock for the period October 22, 1993 through October 31, 1994, and Price Common Stock and Costco Common Stock for the periods indicated. The quotations are as reported in published financial sources.
All Costco common share data has been adjusted to reflect a two-for-one stock split effected April 30, 1991 and a three-for-two stock split effected March 6, 1992. All Price common share data has been adjusted to reflect the 2.13 exchange ratio in the Merger.
On October 31, 1994, the last reported sales price per share of PriceCostco Common Stock was $15.75. On October 31, 1994, the Company had approximately 13,811 stockholders of record.
DIVIDEND POLICY
PriceCostco does not pay regular dividends and does not anticipate the declaration of a cash dividend in the forseeable future. Under its two revolving credit agreements, PriceCostco is generally permitted to pay dividends in any fiscal year up to an amount equal to 50% of its consolidated net income for that fiscal year.
ITEM 6
ITEM 6 -- SELECTED FINANCIAL DATA
SELECTED FINANCIAL AND OPERATING DATA
The following tables set forth selected financial and operating data for the ten fiscal years in the period ended August 28, 1994 for PriceCostco, giving effect to the Merger using the pooling-of-interests method of accounting and treating the non-club real estate segment as a discontinued operation. This selected financial and operating data should be read in conjunction with "Item 7
ITEM 7 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
COMPARISON OF FISCAL 1994 (52 WEEKS) AND FISCAL 1993 (52 WEEKS): (DOLLARS IN THOUSANDS, EXCEPT EARNINGS PER SHARE)
Net operating results for fiscal 1994 reflect a net loss of $112,368 or $.51 per share (fully diluted), as compared to fiscal 1993 net income of $223,247 or $1.00 per share (fully diluted). This loss includes the previously announced provision for merger and restructuring costs of $120,000 pre-tax ($80,000 or $.36 per share after tax) related to the Merger. The Merger was approved by Price and Costco shareholders on October 21, 1993. The fiscal 1994 net loss includes a $40,766 or $.19 per share loss from discontinued operations, compared to income of $20,404 or $.08 per share in fiscal 1993. The fiscal 1994 loss from discontinued operations includes a provision of $80,500 pre-tax ($47,500 or $.22 per share after tax) arising from a change in accounting estimates caused by the Exchange Transaction. In addition, the fiscal 1994 net loss includes a charge of $182,500, or $.83 per share, reflecting the estimated loss on disposal of the discontinued non-club real estate operations.
CONTINUING OPERATIONS
Income from continuing operations for fiscal 1994 was $110,898 or $.51 per share, compared to income from continuing operations for fiscal 1993 of $202,843 or $.92 per share. Excluding the $120,000 pre-tax merger and restructuring charge, income from continuing operations for fiscal 1994 would have been $190,898 or $.87 per share.
Net sales increased 6.6% to $16,160,911 in fiscal 1994 from $15,154,685 in fiscal 1993. This increase was due to: (i) first year sales at the 29 new warehouses opened during fiscal 1994, which increase was partially offset by 8 warehouses closed during fiscal 1994 that were in operation during fiscal 1993; and (ii) increased sales at thirty-seven warehouses that were opened in 1993 and that were in operation for the entire 1994 fiscal year, which increase was partially offset by lower sales at existing locations opened prior to fiscal 1993. Changes in prices did not materially impact sales levels.
Comparable sales, that is sales in warehouses open for at least a year, were a negative 3% annual rate in fiscal 1994 -- similar to the negative 3% annual rate during fiscal 1993. The negative rate of comparable sales was attributed to several factors, including the following: the effect of sales cannibalization by opening additional warehouses in existing markets; increased competition in several markets; deflation in several merchandise categories; a generally poor economic environment, especially in California; and a weak Canadian dollar where the Company derived 16% and 15% of net sales in fiscal 1994 and 1993, respectively.
Membership fees and other revenue increased 3.4% from $309,129, or 2.04% of net sales, in fiscal 1993 to $319,732, or 1.98% of net sales in fiscal 1994. This increase reflects membership signups at the twenty-nine new warehouses and the partial year effect of membership fee increases implemented in January 1994. As anticipated, the Company experienced a decline in membership renewals at existing warehouses due to overlapping memberships and offering Price and Costco members reciprocal member privileges effective November 1, 1993. The negative impact of the reciprocal member privileges on membership fee revenue is expected to be a less significant factor after November 1994.
Gross margin (defined as net sales minus merchandise costs) increased 6.7% from $1,403,532, or 9.26% of net sales in fiscal 1993 to $1,498,020, or 9.27% of net sales in fiscal 1994. The gross margin figures reflect accounting for merchandise inventory costs on the last-in, first-out (LIFO) method. For fiscal 1994 there was a $2,600 LIFO benefit or $.01 per share (fully diluted) to increase income after tax due to the use of the LIFO method compared to the first-in, first-out (FIFO) method. This compares to a $5,350 LIFO benefit or $.01 per share (fully diluted) in fiscal 1993.
Selling, general and administrative expenses as a percent of net sales increased from 8.67% during fiscal 1993 to 8.82% during fiscal 1994, reflecting a combination of comparable unit sales decreases in the 200 warehouses in operation during both fiscal periods; higher expense ratios at the
29 units opened during fiscal 1994 (newer units generally operate at significantly lower annual sales volumes than mature units and, therefore, incur higher expense ratios than mature units); and higher expense factors associated with certain ancillary operations.
Preopening expenses totaled $24,564 or 0.15% of net sales during fiscal 1994 and $28,172 or 0.19% of net sales during fiscal 1993. During fiscal 1994, the Company opened 29 new warehouses compared to opening 37 new warehouses during fiscal 1993.
The Company recorded a pre-tax provision for warehouse closing costs of $7,500 or $.02 per share on an after-tax basis (fully diluted). The provision includes $5,750 (pre-tax) related to settlement of a lease dispute and additional closing costs related to warehouse clubs closed in prior years, and $1,750 (pre-tax) related to the estimated closing costs of six warehouses which were or will be replaced by new warehouses by December 31, 1994. This compares to $5,000 (pre-tax) or .01 per share in fiscal 1993.
Interest expense totaled $46,116 in fiscal 1993 and $50,472 in fiscal 1994. In both fiscal years interest expense was incurred as a result of the interest on the convertible subordinated debentures and interest on borrowings on the Company's bank lines and commercial paper programs.
Interest income and other totaled $17,750 in fiscal 1993, and $13,888 in fiscal 1994. This decrease was primarily due to lower average investment balances and lower interest rates.
The effective income tax rate (excluding the merger and restructuring charge and loss on disposal of the discontinued operations) on earnings in fiscal 1994 was 41.0%, compared to 39.7% in the prior year. The Company's effective income tax rate increased due to a higher federal statutory rate implemented in the Company's fourth quarter of fiscal 1993 and by changes in the impact of foreign operations on the effective tax rate.
DISCONTINUED OPERATIONS
The loss on discontinued real estate operations (net of operating expenses and taxes) includes the results of income producing properties, gains on sale of property, interest income and a provision of $90,200 pre-tax of which $80,500 pre-tax ($47,500 after tax or or $.22 per share) relates to a change in calculating estimated losses for assets which are considered to be economically impaired. This change in accounting estimates results from the spin-off of the real estate segment assets into Price Enterprises, and Price Enterprises' decision to pursue business plans and operating strategies as a stand-alone entity which are significantly different than the strategies of the Company. Specifically, Price Enterprises' management believes that as a separate operating business it will not have the same access to capital as the Company or generate internal funds from operations to the same extent as the Company.
PriceCostco's accounting policies with respect to estimating the amount of impairments on individual real estate properties and related assets such that impairment losses if the carrying amount of the asset could not be recovered from estimated future cash flows on an undiscounted basis. Price Enterprises management believes that in view of its strategies with respect to the number and nature of properties that would be selected for potential disposition, it would be more appropriate to estimate impairment losses based on fair values of the real estate properties as determined by appraisals and/or a risk-adjusted discounted cash flow approach. In determining impairment losses, individual real estate assets were reduced to estimated fair value, if lower than historical cost. For those assets which have an estimated fair value in excess of cost, the asset continues to be recorded at cost. The impairment losses recorded as a result of this change in accounting estimates reduced the book basis of certain of the real estate and related assets.
The loss on disposal of the discontinued real estate operations of $182,500 or $.83 per share, reflected in the fourth quarter of fiscal 1994, relates to the transfer of the Company's commercial real estate operations, together with certain other assets, to Price Enterprises as part of the Exchange Transaction. For a description of the Exchange Transaction, see "Part I -- Business -- Description of
the Exchange Transaction." The estimated loss on disposal is a non-recurring special charge calculated as the difference between the aggregate book value of the net assets being spun-off of $579,000 and the estimated market value of 27 million shares of Price Enterprises common stock of $411,750 plus direct transaction costs of approximately $15,250. The Exchange Transaction is expected to close before the end of the calendar year, at which time the estimated loss on disposal will be adjusted to actual. For a more detailed discussion of the estimated loss on disposal and the factors that will affect the amount of any adjustment to the loss after the Transaction is completed, see Note 3 -- Spin off of Price Enterprises, Inc. and Discontinued Operations.
COMPARISON OF FISCAL 1993 (52 WEEKS) AND FISCAL 1992 (52 WEEKS): (DOLLARS IN THOUSANDS, EXCEPT EARNINGS PER SHARE)
Net income during fiscal 1993 decreased 8% to $223,247, or $1.00 per share (fully diluted), as compared to fiscal 1992 net income of $242,407 or $1.06 per share (fully diluted).
CONTINUING OPERATIONS
Income from continuing operations for fiscal 1993 was $202,843 or $.92 per share, compared to fiscal 1992 income from continuing operations of $223,022 or $.98 per share.
Net sales increased 10% to $15,154,685 in fiscal 1993 from $13,820,380 in fiscal 1992. This increase was due to: (i) first year sales at the thirty-seven new warehouses opened during fiscal 1993; and (ii) increased sales at thirty-one warehouses that were opened in 1992 and that were in operation for the entire fiscal year, which increase was partially offset by lower sales at existing locations opened prior to fiscal 1992. Changes in prices did not materially affect sales levels.
Comparable sales, that is sales in warehouses open for at least a year, trended downward in fiscal 1993 -- from a positive 6% annual rate during fiscal 1992, to a negative 3% annual rate during fiscal 1993. The declining rate of comparable sales was attributed to several factors, including the following: the effect of sales cannibalization by opening additional warehouses in existing markets; increased competition in several markets; deflation in several merchandise categories; a generally poor economic environment, especially in California; and a weak Canadian dollar where the Company derived 15% and 14% of net sales in fiscal 1993 and 1992, respectively.
Membership fees and other revenue increased 12% from $276,998, or 2.00% of net sales, in fiscal 1992 to $309,129, or 2.04% of net sales in fiscal 1993. This increase reflects a continued strong membership base at existing warehouses, membership signups at the thirty-seven new warehouses and annualized effect of membership fee increases in certain markets implemented in fiscal 1992.
Gross margin (defined as net sales minus merchandise costs) increased 12% from $1,254,917, or 9.08% of net sales in fiscal 1992 to $1,403,532, or 9.26% of net sales in fiscal 1993. The increased gross margin reflects improved shrinkage control and improved buying and distribution techniques afforded by the Company's increased sales volume, as well as increased levels of sales from ancillary businesses (pharmacy, one-hour photo, print shop, optical and food services), which carry a higher than average gross margin. The gross margin figures reflect accounting for merchandise inventory costs on the last-in, first-out (LIFO) method. For fiscal 1993 there was a $5,350 LIFO benefit or $.01 per share (fully diluted) to increase income after tax due to the use of the LIFO method compared to the first-in, first-out (FIFO) method. This compares to a $300 LIFO provision in fiscal 1992.
Selling, general and administrative expenses as a percent of net sales increased from 8.17% during fiscal 1992 to 8.67% during fiscal 1993, reflecting a combination of comparable unit sales decreases in the 170 warehouses in operation during both fiscal periods; higher expense ratios at the 37 units opened during fiscal 1993 (newer units generally operate at significantly lower annual sales volumes than mature units and, therefore, incur higher expense ratios than mature units); and higher expense factors associated with certain ancillary operations.
Preopening expenses totaled $25,595 or 0.19% of net sales during fiscal 1992 and $28,172 or 0.19% of net sales during fiscal 1993. During fiscal 1993, the Company opened 37 new warehouses. The Company opened 31 new warehouses during fiscal 1992.
During fiscal 1993, the Company announced and closed four warehouses and completed the closing and relocation of three warehouses announced in fiscal 1992. The costs associated with closing the four warehouses announced in fiscal 1993 will be approximately $5,000, or $.01 per share (fully diluted), and this amount was recognized as anticipated warehouse closing costs in the fourth quarter of fiscal 1993. This compares to $2,000 in fiscal 1992, when the Company announced the closing of two warehouses, relocated one warehouse and announced the planned relocation of another warehouse.
Interest expense totaled $35,525 in fiscal 1992 and $46,116 in fiscal 1993. In fiscal 1992 interest expense was incurred as a result of the interest on the convertible subordinated debentures and interest on borrowings on the Company's bank lines. Fiscal 1993 includes a full year of interest expense on the $300,000 5 3/4% convertible subordinated debentures which accounted for the increase in interest expense compared to fiscal 1992.
Interest income and other totaled $28,958 in fiscal 1992, and $17,750 in fiscal 1993. This decrease was primarily due to lower average investment balances and lower interest rates.
The effective income tax rate on earnings in fiscal 1993 was 39.7%, compared to 39.5% the prior year. The Company's effective income tax rate increased due to a higher federal statutory rate implemented in the Company's fourth quarter of 1993 offset by changes in state and foreign effective rates.
DISCONTINUED OPERATIONS
Discontinued real estate operations (net of operating expenses and taxes) includes the results of income producing properties as well as gains (losses) on sales of property. Income from discontinued real estate operations, net of income taxes, increased 5% from $19,385 or $0.08 per share in fiscal 1992 to $20,404 or $0.08 per share in fiscal 1993. The increase primarily represents nonrecurring gains recognized on sale of properties of $21,500 in fiscal 1993 as compared to $15,600 in fiscal 1992.
RECENT SALES RESULTS
PriceCostco's net sales for the eight-week period ended October 23, 1994 were approximately $2,520,000 an increase of 11% from approximately $2,280,000 for the same eight-week period of the prior fiscal year. Comparable warehouse sales (sales in warehouses open for at least a year) increased by one percent during the eight-week period.
LIQUIDITY AND CAPITAL RESOURCES (DOLLARS IN THOUSANDS)
PriceCostco's primary requirement for capital is the financing of the land, building and equipment costs for new warehouses plus the costs of initial warehouse operations and working capital requirements. PriceCostco does not expect to make significant investments in non-club real estate in the future. Additional capital will be required for international expansion through investments in foreign subsidiaries and joint ventures.
In fiscal 1994, cash provided from operations was approximately $248,000. These funds, combined with beginning fiscal year balances of cash, cash equivalents and short-term investments, along with borrowings under the Company's commercial paper program were used to finance additions to property, equipment for warehouse clubs and related operations of $475,000 and net inventory investment (merchandise inventories less accounts payable) of $66,000 and other investing activities related primarily to non-club real estate investments and investments in foreign joint ventures, which together totaled $125,000.
Expansion plans for the United States and Canada during fiscal 1995 are to open 30-35 new warehouse clubs. The Company also expects to continue expansion of its international operations.
The Company opened two warehouses in the United Kingdom through a 60%-owned subsidiary, with a third location due to open in June, 1995. In October 1994, under a licensing agreement with PriceCostco, a Price Club opened in Seoul, Korea. Other markets are being assessed, particularly in the Pacific Rim. As a result of the Exchange Transaction, the Company's 50% ownership interest in the Mexican joint venture was transferred to Mexico Clubs in which the Company owns a 49% interest. See "Part I -- Business -- Description of the Exchange Transaction." As of August 28, 1994, there were 8 Price Clubs operating in Mexico through such joint venture. As of October 31, 1994, there are 10 Price Clubs operating in Mexico through such joint venture with one more scheduled to open prior to December 31, 1994.
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 $500,000 to $600,000 during fiscal 1995 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 and other potential ventures. These expenditures will be financed with a combination of cash provided from operations, the use of cash, cash equivalents and short-term investments, which totaled $63,000 at August 28, 1994; short-term borrowings under revolving credit facilities and/or commercial paper facilities; issuance of long-term debt; and other financing sources as required.
The Company has a domestic multiple option loan facility with a group of 14 banks which provides for borrowings of up to $500,000 or for standby support for a $500,000 commercial paper program. Of this amount, $250,000 expires on January 30, 1995, and $250,000 expires on January 30, 1998. The interest rate on bank borrowings is based on LIBOR or rates bid at auction by the participating banks. At August 28, 1994, in the amount outstanding under the Company's commercial paper program was $149,340. The Company expects to renew the $250,000 portion of the loan facility expiring on January 30, 1995, at substantially the same terms.
In addition, the Company's wholly-owned Canadian subsidiary has a $65,800 line of credit with a group of three Canadian banks of which $29,200 expires on December 1, 1994 (the short-term portion) and $36,600 expires in various amounts through December 1, 1996 (the long-term portion). The interest rate on borrowings is based on the prime rate or the "Bankers' Acceptance" rate. At August 28, 1994, no amounts were outstanding under these programs. The Company expects to renew the $29,200 short-term portion of the line of credit expiring on December 1, 1994, at substantially the same terms.
The Company has separate letter of credit facilities (for commercial and standby letters of credit), totaling approximately $193,000. The outstanding commitments under these facilities at August 28, 1994 was approximately $118,000, including approximately $53,000 in standby letters for workers' compensation requirements.
Due to rapid inventory turnover, the Company's operations provide a higher level of supplier trade payables than generally encountered in other forms of retailing. When combined with other current liabilities, the resulting amount typically approaches the current assets needed to operate the business (e.g., merchandise inventories, accounts receivable and other current assets). At August 28, 1994, the working capital (deficit) totaled ($113,000) compared to working capital of $127,000 at August 29, 1993. This change is primarily related to a reduction in cash and cash equivalents of $67,000, a decrease in short-term investments and restricted cash of $81,000 and an increase in notes payable of $126,000 offset by other increases of $34,000, as working capital was used to finance expansion and merger expenses during fiscal 1994.
In fiscal 1992, cash provided from operations was $296,000. These funds combined with proceeds from issuance of $300,000 5 3/4% convertible subordinated debentures in May 1992 and approximately $144,000 generated from the sale of certain properties were used to finance additions to property and
equipment for warehouse clubs and related operations of $533,000; other investing activities related primarily to non-club real estate development, and investment in foreign joint ventures, which together totaled $83,000.
ITEM 8
ITEM 8 -- FINANCIAL STATEMENTS
The following financial statements of PriceCostco are as follows:
ITEM 9
ITEM 9 -- CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10
ITEM 10 -- DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
For information with respect to the executive officers of the Registrant, see Item 4A -- "Executive Officers of the Registrant" at the end of Part I of this report. The information required by this Item concerning the Directors and nominees for Director of the Company is incorporated herein by reference to PriceCostco's Proxy Statement for its Annual Meeting of Stockholders, to be held on January 27, 1995, to be filed with the Commission pursuant to Regulation 14A.
ITEM 11
ITEM 11 -- EXECUTIVE COMPENSATION
The information required by this Item is incorporated herein by reference to PriceCostco's Proxy Statement for its Annual Meeting of Stockholders, to be held on January 27, 1995, to be filed with the Commission pursuant to Regulation 14A.
ITEM 12
ITEM 12 -- SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is incorporated herein by reference to PriceCostco's Proxy Statement for its Annual Meeting of Stockholders to be held on January 27, 1995, to be filed with the Commission pursuant to Regulation 14A.
ITEM 13
ITEM 13 -- CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is incorporated herein by reference to PriceCostco's Proxy Statement for its Annual Meeting of Stockholders, to be held on January 27, 1995, to be filed with the Commission pursuant to Regulation 14A.
PART IV
ITEM 14
ITEM 14 -- EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report are as follows:
1. Financial Statements:
See listing of Financial Statements included as a part of this Form 10-K on Item 8 of Part II.
2. Financial Statements Schedules:
(b) Current Report on Form 8-K filed on August 5, 1994.
3. Exhibits
The following exhibits are filed as part of this Annual Report on Form 10-K or are incorporated herein by reference. Where an exhibit is incorporated by reference, the number which follows the description of the exhibit indicates the document to which cross reference is made (see page 22 for listing of cross reference documents).
SIGNATURES
Pursuant to the requirements of Section 13 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.
November 16, 1994
PRICE/COSTCO, INC.
(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.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Price/Costco, Inc.:
We have audited the accompanying consolidated balance sheets of Price/Costco, Inc. (a Delaware corporation) and subsidiaries (PriceCostco) as of August 28, 1994 and August 29, 1993, and the related statements of operations, stockholders' equity and cash flows for the 52-week periods ended August 28, 1994, August 29, 1993 and August 30, 1992. These financial statements are the responsibility of PriceCostco's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We did not audit the financial statements of The Price Company and subsidiaries (Price), which statements reflect total assets of 52% of the consolidated totals as of August 29, 1993 and total revenues of 51% and 53% of the consolidated totals for the 52-week periods ended August 29, 1993 and August 30, 1992, respectively. Those statements were audited by other auditors whose report thereon has been furnished to us and our opinion expressed herein, insofar as it relates to the amounts included for Price, is based solely on the report of the other auditors.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of PriceCostco as of August 28, 1994 and August 29, 1993, and the results of its operations and its cash flows for the 52-week periods ended August 28, 1994, August 29, 1993 and August 30, 1992 in conformity with generally accepted accounting principles.
Arthur Andersen LLP
Seattle, Washington November 14, 1994
PRICE/COSTCO, INC. CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS) ASSETS
The accompanying notes are an integral part of these balance sheets.
PRICE/COSTCO, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
The accompanying notes are an integral part of these statements.
PRICE/COSTCO, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE 52 WEEKS ENDED AUGUST 28, 1994, AUGUST 29, 1993, AND AUGUST 30, 1992 (IN THOUSANDS)
The accompanying notes are an integral part of these statements.
PRICE/COSTCO, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS)
The accompanying notes are an integral part of these statements.
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of Price/Costco, Inc., a Delaware corporation, and its subsidiaries (PriceCostco or the Company). PriceCostco is a holding company which operates primarily through its major subsidiaries, The Price Company and subsidiaries (Price), and Costco Wholesale Corporation and subsidiaries (Costco). As described more fully in Note 2 -- Merger of Price and Costco, on October 21, 1993, Price and Costco became wholly-owned subsidiaries of PriceCostco.
As described more fully in "Note 3 -- Spin-off of Price Enterprises, Inc. and Discontinued Operations" the Company has treated the spin-off of its real estate operations as discontinued operations in the fourth quarter of fiscal 1994.
The Company's investment in the Mexico joint venture and in real estate joint ventures that are less than majority owned are accounted for under the equity method.
BUSINESS
The Company has operated in two reporting business segments, a cash and carry merchandising operation and as of July 1994 has discontinued its non-club real estate operations. The Company reports on a 52/53 week basis and ends on the Sunday nearest August 31st. Fiscal years 1994, 1993 and 1992 were each 52 weeks.
CASH AND CASH EQUIVALENTS
The Company considers all investments in highly liquid debt instruments maturing within 90 days when purchased as cash equivalents unless amounts are held in escrow for future property purchases or restricted by agreements.
SHORT-TERM INVESTMENTS AND RESTRICTED CASH
Short-term investments include highly liquid investments in United States and Canadian government obligations, along with other investment vehicles, some of which have maturities of three months or less at the time of purchase. The Company's policy is to classify these investments as short-term investments rather than cash equivalents if they are acquired and disposed of through its investment trading account, held for future property purchases, or restricted by agreement.
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 U.S. merchandise inventories. The Company believes the LIFO method more fairly presents the results of operations by more closely matching current costs with current revenues. If all merchandise inventories had been valued using the first-in, first-out (FIFO) method, inventories would have been higher by $6,650 at August 28, 1994, $9,250 at August 29, 1993 and $14,600 at August 30, 1992.
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) 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.
When required in the normal course of business, the Company enters into agreements securing vendor interests in inventories.
RECEIVABLES
Current receivables consist of vendor rebates and other miscellaneous amounts due to the Company, and are net of allowance for doubtful accounts of $3,045 at August 28, 1994 and $1,567 at August 29, 1993.
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 and by accelerated methods for tax purposes. Buildings are depreciated over twenty-five to thirty-five years; equipment and fixtures are depreciated over three to ten years; and land rights and leasehold improvements are amortized over the initial term of the lease.
Interest costs incurred on property and equipment during the construction period are capitalized. The amount of interest costs capitalized related to continuing operations was approximately $7,170 in fiscal 1994, $9,483 in fiscal 1993 and $8,487 in fiscal 1992.
GOODWILL
Goodwill included in other assets totaled $38,761 at August 28, 1994 and $41,725 at August 29, 1993 resulted from certain previous business combinations. Goodwill is being amortized over 5 to 40 years using the straight-line method. Accumulated amortization was $5,986 at August 28, 1994 and $5,575 at August 29, 1993.
NET INCOME PER COMMON AND COMMON EQUIVALENT SHARE
The calculation of net income per common and common equivalent share for each period presented prior to the Merger reflects the issuance of 2.13 shares of PriceCostco Common Stock for each share of Price Common Stock used in such calculation and one share of PriceCostco Common Stock for each share of Costco Common Stock used in such calculation. For fiscal 1993 and 1992, this calculation eliminates interest expense, net of income taxes, on the 5 1/2% convertible subordinated debentures (primary and fully diluted) and the 6 3/4% convertible subordinated debentures (fully diluted only), and includes the additional shares issuable upon conversion of these debentures. For fiscal 1994, the 6 3/4% and 5 1/2% convertible subordinated debentures were not dilutive for either primary or fully diluted purposes. For all periods presented, the 5 3/4% convertible subordinated debentures were not dilutive for either primary or fully diluted purposes. The weighted average number of common and common equivalent shares outstanding for primary and fully diluted share calculations for fiscal 1994, 1993 and 1992 were as follows (in thousands):
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) PREOPENING EXPENSES
Preopening expenses related to new warehouses, regional offices and other startup operations are expensed as incurred.
MEMBERSHIP FEES
Membership fee revenue represents annual membership fees paid by substantially all of the Company's members. In accordance with industry practice, annual membership fees are recognized as income when received.
FOREIGN CURRENCY TRANSLATION
The accumulated foreign currency translation relates to the Company's consolidated foreign operations and its investment in the Price Club Mexico joint venture and is determined by application of the current rate method and included in the determination of consolidated stockholders' equity at the respective balance sheet dates.
INCOME TAXES
The Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." That standard requires companies to account for deferred income taxes using the asset and liability method.
RECLASSIFICATIONS
Certain reclassifications of expenses between merchandise costs and selling, general and administrative expenses have been reflected in the financial statements in order to conform the presentations of the combined entities.
NOTE 2 -- MERGER OF PRICE AND COSTCO On October 21, 1993, the shareholders of both Price and Costco approved the mergers of Price and Costco into subsidiaries of PriceCostco (the Merger). Pursuant to the Merger, Price and Costco became subsidiaries of PriceCostco. Shareholders of Price received 2.13 shares of PriceCostco common stock for each share of Price common stock and shareholders of Costco received one share of PriceCostco common stock for each share of Costco.
The Merger qualified as a "pooling-of-interests" for accounting and financial reporting purposes. The pooling-of-interests method of accounting is intended to present as a single interest two or more common shareholder interests which were previously independent. Consequently, the historical financial statements for periods prior to the consummation of the combination were restated as though the companies had been combined. The restated financial statements were adjusted to conform the accounting policies of the separate companies.
All fees and expenses related to the Merger and to the consolidation and restructuring of the combined companies were expensed as required under the pooling-of-interests accounting method. In the first quarter of fiscal 1994, the Company recorded a provision for merger and restructuring costs of $120,000 pre-tax ($80,000 after tax) related to the Merger.
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 2 -- MERGER OF PRICE AND COSTCO (CONTINUED) Components of the $120,000 provision for merger and restructuring expenses, including amounts expended in Fiscal 1994 and the remaining accrual related to completing the merger and restructuring effort at August 28, 1994, are as follows:
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 2 -- MERGER OF PRICE AND COSTCO (CONTINUED) The following summarizes amounts reported by Price and Costco prior to the Merger for fiscal 1994, 1993 and 1992.
NOTE 3 -- SPIN-OFF OF PRICE ENTERPRISES, INC. AND DISCONTINUED OPERATIONS
SPIN-OFF OF PRICE ENTERPRISES, INC.
On July 28, 1994, PriceCostco entered into an Agreement of Transfer and Plan of Exchange (as amended and restated, the Transfer and Exchange Agreement) with Price Enterprises, Inc. (Price Enterprises). Price Enterprises is an indirect, wholly-owned subsidiary of PriceCostco, formed in July 1994. The transactions contemplated by the Transfer and Exchange Agreement are referred to herein as the "Exchange Transaction."
Pursuant to the Transfer and Exchange Agreement, PriceCostco will offer to exchange one share of Price Enterprises Common Stock for each share of PriceCostco Common Stock, up to a maximum of 27 million shares of Price Enterprises Common Stock (the Exchange Offer). If more than 27 million shares of PriceCostco Common Stock are validly tendered and not withdrawn in the Exchange Offer prior to the expiration thereof, then PriceCostco will accept 27 million shares on a pro rata basis and shares of Price Enterprises Common Stock will be exchanged therefor. If the number of shares of PriceCostco Common Stock validly tendered in the Exchange Offer by holders of PriceCostco Common Stock is less than 21.6 million, PriceCostco will accept such validly tendered shares for exchange and will distribute the remaining shares of Price Enterprises Common Stock pro rata to PriceCostco
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 3 -- SPIN-OFF OF PRICE ENTERPRISES, INC. AND DISCONTINUED OPERATIONS (CONTINUED) stockholders. If the number of shares of PriceCostco Common Stock validly tendered in the Exchange Offer by holders of PriceCostco Common Stock is greater than 21.6 million, but less than 27 million, PriceCostco will accept such validly tendered shares for exchange and will, at its option, either (i) distribute the remaining shares of Price Enterprises Common Stock pro rata to PriceCostco stockholders or (ii) sell such remaining shares to Price Enterprises in exchange for a promissory note.
The following real estate related assets have been or will be transferred to Price Enterprises:
- Substantially all of the real estate properties which historically formed the non-club real estate segment of PriceCostco.
- Four existing Price Club warehouses ("Warehouse Properties") which are adjacent to existing non-club real estate properties which are being leased back to PriceCostco effective August 29, 1994, at initial collective annual rentals of approximately $8,600.
- Notes receivable from various municipalities and agencies ("City Notes").
- Note receivable in the principal amount of $41,000 made by Atlas Hotels, Inc., secured by a hotel and convention center property located in San Diego, California ("Atlas Note").
In addition, PriceCostco agreed to transfer to Price Enterprises 51% of the outstanding capital stock of two newly formed, wholly owned subsidiaries of the Company: Price Quest, Inc. (Price Quest) and Price Global Trading, Inc. (Price Global), Price and Price Enterprises also own 49% and 51% interests, respectively, in Mexico Clubs, L.L.C., a limited liability company (Mexico Clubs, which together with Price Quest and Price Global comprise the Subsidiary Corporations).
Mexico Clubs will own the Company's 50% interest in Price Club de Mexico and affiliates (Price Club Mexico), a 50-50 joint venture with Controladora Comercial Mexicana S.A. de C.V., which develops, owns and operates Price Clubs in Mexico. The investment in Price Club Mexico is accounted for under the equity method. At August 28, 1994, eight Price Clubs were in operation in Mexico. The Company owns a 49% interest in Mexico Clubs.
Price Quest will continue to operate the Quest interactive electronic shopping business of PriceCostco. The Quest business includes electronic shopping through kiosks located in certain PriceCostco club warehouses; Price Club Travel, which offers discount airline tickets and travel packages to PriceCostco members; Price Club Realty, a real estate brokerage business for PriceCostco members; and the Price Club automobile referral/advertising program, which publishes advertisements for automobile dealers who provide discount purchasing programs to PriceCostco members in the vicinity of certain PriceCostco warehouse clubs. The Company owns 49% of the capital stock of Price Quest.
Price Global has the rights to develop club businesses in certain geographical areas specified in the Transfer and Exchange Agreement and owns 100% of the outstanding shares of Club Merchandising, Inc. (CMI), which was acquired by the Company in March 1992. The Company owns 49% of the capital stock of Price Global.
For purposes of governing the ongoing relationships between PriceCostco, Price Enterprises, and the Subsidiary Corporations, PriceCostco and Price, on the one hand, and Price Enterprises and the Subsidiary Corporations, on the other, have entered into operating agreements. PriceCostco and Price, on the one hand, and Price Enterprises and each of Price Global and Price Quest, on the other, have entered into stockholders agreements to clarify certain rights and obligation of PriceCostco and Price Enterprises as stockholders of Price Global and Price Quest. Price and Price Enterprises have
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 3 -- SPIN-OFF OF PRICE ENTERPRISES, INC. AND DISCONTINUED OPERATIONS (CONTINUED) entered into a Limited Liability Company Agreement with respect to Mexico Clubs that sets forth the rights and obligations of each of Price and Price Enterprises with respect to its membership interest in Mexico Clubs. PriceCostco and Price Enterprises have entered into an unsecured revolving credit agreement under which PriceCostco has agreed to advance Price Enterprises up to a maximum principal amount of $85 million (reduced by the net proceeds from the sale of certain commercial properties).
DISCONTINUED OPERATIONS
Historically, the Company has treated non-club real estate investments as a separate reportable business segment. The primary assets generating operating income for the segment have been non-club real estate properties, consisting of property owned directly and property owned by real estate joint venture partnerships in which the Company has a controlling interest. Real estate joint ventures relate to real estate partnerships that are less than majority owned. In fiscal 1994, the Atlas Note was purchased and the related interest income has been included in the non-club real estate segment.
Additionally, the Warehouse Properties, and City Notes transferred to Price Enterprises as of August 28, 1994 have been included in the net assets of the discontinued operations as of August 28, 1994 and August 29, 1993, in the accompanying consolidated balance sheets. However, the operating expenses of the Warehouse Properties and the interest income on the City Notes have not been included in the real estate segment operating results because historically these amounts have been included as part of merchandising operations and other income. The operating results and net assets of the Subsidiary Corporations transferred to Price Enterprises are included in continuing operations because they were not related to the discontinued real estate operations.
DISCONTINUED OPERATIONS -- NET ASSETS
Net assets related to discontinued real estate operations as shown on the consolidated balance sheets at August 28, 1994 and August 29, 1993 consist of the following:
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 3 -- SPIN-OFF OF PRICE ENTERPRISES, INC. AND DISCONTINUED OPERATIONS (CONTINUED) INCOME (LOSS) FROM DISCONTINUED OPERATIONS
Components of net income (loss) from discontinued operations for fiscal 1994, 1993 and 1992 were as follows:
PROVISION FOR ASSET IMPAIRMENTS
The loss on discontinued real estate operations includes a provision of $90,200 of which $80,500 ($47,500 after tax) relates to a change in calculating estimated losses for assets which are economically impaired. This change in accounting estimates results from the spin-off of the real estate segment assets into Price Enterprises and Price Enterprises' decision to pursue business plans and operating strategies as a stand-alone entity which are significantly different than the previous strategies of the Company. Price Enterprises' management believes that as a separate operating business it will not have the same access to capital as the Company or generate internal funds from operations to the same extent as the Company.
PriceCostco's accounting policies with respect to estimating the amount of impairments on individual real estate properties and related assets were such that impairment losses would be recorded if the carrying amount of the asset could not be recovered from estimated future cash flows on an undiscounted basis. Price Enterprises' management believes that in view of its strategies with respect to the number and nature of properties that would be selected for disposition, it would be more appropriate to estimate impairment losses based on fair values of the real estate properties as determined by appraisals and/or a risk-adjusted discounted cash flow approach. In determining impairment losses, individual real estate assets were reduced to estimated fair value, if lower than historical cost. For those assets which have an estimated fair value in excess of cost, the asset continues to be recorded at cost. The impairment losses recorded as a result of this change in accounting estimates reduced the book basis of certain of the real estate and related assets.
Under the previous policy, PriceCostco and Price Enterprise had determined that a provision for asset impairments of approximately $9,700 was required relating to four properties which were under contract or in final negotiations for sale.
GAINS ON SALE OF NON-CLUB REAL ESTATE PROPERTIES
During fiscal 1994, the Company entered into a transaction with The Price REIT, Inc. (REIT). On October 1, 1993, the Company sold a single shopping center and adjacent Price Club (which is being leased back to the Company) for $28,200. The Company recorded a $4,210 pre-tax gain in connection with this sale.
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 3 -- SPIN-OFF OF PRICE ENTERPRISES, INC. AND DISCONTINUED OPERATIONS (CONTINUED) During fiscal 1993, the Company entered into two transactions with the REIT:
(a) On December 18, 1992, the Company sold a former Price Club property for $14,350. The Company recorded a pre-tax gain of $6,710 in connection with this sale.
(b) On August 12, 1993, the Company sold three shopping centers and adjacent Price Clubs (which are being leased back to the Company) and its 49.6% interest in a joint venture which owns five shopping centers, for which the Company received proceeds of approximately $117,000 and recognized a $14,320 pre-tax gain.
During fiscal 1992, the Company entered into two transactions with the REIT:
(a) On December 1, 1991 the Company entered into a sale and leaseback transaction, under which four Price Clubs were sold to the REIT for $26,700 and leased back for annual rentals of $2,470, increasing $27 each year. The master lease has an initial term of 15 years with seven five-year renewal options. Additionally, the Company sold a 50.4% interest in five shopping centers, four of which are adjacent to the Price Clubs involved in the sale-leaseback. The Company agreed, for a specified period, to subordinate its portion of the operational cash flow of the joint venture to allow the REIT shareholders to receive a specified return on their investment (9% the first year, increasing to 9.5% in year five). The Company recorded a pretax gain of $4,400 in connection with this sale.
(b) On April 29, 1992, the Company sold two shopping centers and one Price Club adjacent to one of the shopping centers for $62,500. The Price Club is being leased back from the REIT for annual rentals of $370, increasing $4 per year, with an initial term of 15 years and seven five-year renewal options. The Company recorded a pre-tax gain of $11,200 in connection with this sale.
For the real estate transactions referred to above, no gains were recognized for the portion of the sales involving Price Club warehouses which are being leased back.
ESTIMATED LOSS ON DISPOSAL AND SUBSEQUENT ADJUSTMENT
In the fourth quarter of fiscal 1994, the Company recorded an estimated loss on disposal of its discontinued operations (the non-club real estate segment) as a result of entering into the Transfer and Exchange Agreement. While the Exchange Transaction is not expected to be completed until December 1994, the Company determined that the Exchange Transaction will, in all likelihood, result in a significant loss for financial reporting purposes and that there is a reasonable basis for estimating the loss. The actual loss for financial reporting purposes will be determined following consummation of the Exchange Transaction. Such loss will be the product of: (a) the difference between the book value per share of the assets transferred to Price Enterprises (at historical cost), and the fair market value per share; and (b) the actual number of shares exchanged. The loss also includes the direct expenses related to the Exchange Transaction. For purposes of recording such estimated loss, the Company assumed that (i) the Exchange Offer would be fully subscribed, (ii) a per share price of Price Enterprises Common Stock of $15.25 (the closing sales price of PriceCostco Common Stock on October 24, 1994) and (iii) direct expenses and other costs related to the Exchange Transaction of approximately $15,250.
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 3 -- SPIN-OFF OF PRICE ENTERPRISES, INC. AND DISCONTINUED OPERATIONS (CONTINUED) The following table explains how the estimated loss was computed:
The book value of the assets transferred to Price Enterprises (approximately $21 per share of Price Enterprises stock), reflects a provision for asset impairments of $80,500 recorded as a change in accounting estimate in the fourth quarter of fiscal 1994.
The approximate $6 per share difference between the $21 book value per share of Price Enterprises and the assumed per share price of Price Enterprises is attributable to a combination of factors. These factors include an expectation that Price Enterprises' stock may trade at a discount from its book value (although the prices at which shares of Price Enterprises will trade cannot be predicted).
In making its determination to approve the Exchange Transaction, one of the factors considered by the Board of Directors of the Company was a range of illustrative high and low per share values for Price Enterprises and the implied per share premium in the Exchange Offer based on such illustrative values as compared to the per share price of PriceCostco common stock at July 14, 1994 of $14.75 (assuming 27 million shares of Price Enterprises common stock outstanding and a one-for-one exchange ratio). While believing that some premium to tendering stockholders is included in the exchange ratio, the Board did not quantify any such premium, recognizing that it could not quantify any such premium since the range of prices at which Price Enterprises Common Stock may trade cannot be predicted. If any such premium could be objectively measured, it would be accounted for as a cost of the treasury shares to be acquired by the Company. Since any premium cannot be objectively measured, the Company believes that it is appropriate in the circumstances to include any premium as part of the estimated loss on the disposal of the non-club real estate segment, recognizing that the amount of the loss is subject to revision after the Exchange Offer closes.
As indicated above, the estimated loss was determined assuming that the Exchange Offer would be fully subscribed. Any subsequent adjustment to the estimated loss will be affected by the extent to which the Exchange Offer is subscribed. If the Exchange Offer is at least 80% subscribed and PriceCostco elects to sell the unsubscribed shares to Price Enterprises for a note, the loss on the Transaction will be the same as if it were fully subscribed. Any unsubscribed shares distributed to stockholders pro rata will be excluded from the loss determination and accounted for as a dividend. The dividend will be measured by the book value per share of Price Enterprises shares distributed and will be is charged directly to retained earnings. Furthermore, to the extent that the Price Enterprises' fair market value per share differs from the estimated share price used above, the per share difference times the number of shares exchanged will be reclassified from the loss on disposal reflected in the income statement and included in the cost of the Company's treasury shares acquired. In measuring the actual loss on the Exchange Transaction, PriceCostco expects to measure the fair market value of Price Enterprises' stock based on the average closing sales price of Price Enterprises Common Stock during the 20 trading days commencing on the sixth trading day following the closing of the Exchange Offer. However, other factors may also need to be considered in making the final determination.
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 3 -- SPIN-OFF OF PRICE ENTERPRISES, INC. AND DISCONTINUED OPERATIONS (CONTINUED) If the Exchange Offer is at least 80% subscribed and PriceCostco decides to sell the unsubscribed shares to Price Enterprises in exchange for a note, the loss on the Transaction will be the same as if it were fully subscribed. Otherwise, the actual loss will be reduced by approximately $6 per share. The actual loss determination will also be affected by the fair market price of Price Enterprises stock. The fair market value of Price Enterprises stock will be used to measure the cost per share of each PriceCostco share acquired in the Exchange Offer. For each dollar per share difference in Price Enterprises' stock value from the $15.25 amount used for purposes of estimating the loss, the actual loss will change by one dollar for every share exchanged. An increase in Price Enterprises' stock value would reduce the amount of the loss, while a decrease in Price Enterprises' stock value would cause the loss to be greater.
Determination of the actual loss will not affect PriceCostco's pro forma balance sheet, because any change in the amount of the loss on disposal, as it is ultimately measured, will result in an offsetting change in stockholders' equity, either as dividends, as an adjustment to the cost of treasury shares being acquired, or both.
UNAUDITED PRO FORMA CONDENSED INFORMATION
The following unaudited pro forma condensed balance sheet of PriceCostco as of August 28, 1994 reflects the unaudited pro forma adjustments of the Exchange Transaction as if it had occurred on August 28, 1994 regardless of the ultimate treatment of the estimated loss on disposal as discussed above:
Pro forma net income from continuing operations was reduced by $2,580 or $.01 per share for the net effect of assets transferred in the Exchange Transaction which were not accounted for as part of discontinued operations. This net effect was caused by rent expense on the Warehouse Properties, income on the City Notes, and equity in earnings of Price Club Mexico, which was offset by the losses on certain merchandising operations.
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 4 -- DEBT
BANK LINES OF CREDIT
The company has a domestic multiple option loan facility with a group of 14 banks which provides for borrowings of up to $500,000 or for standby support for a $500,000 commercial paper program. Of this amount, $250,000 expires on January 30, 1995, and $250,000 expires on January 30, 1998. The interest rate on bank borrowings is based on LIBOR or rates bid at auction by the participating banks. Notes payable at August 28, 1994, in the accompanying balance sheet consist of amounts outstanding under the Company's commercial paper program. The Company expects to renew the $250,000 portion of the loan facility expiring on January 30, 1995, at substantially the same terms.
In addition, the Company's wholly-owned Canadian subsidiary has a $65,800 line of credit with a group of three Canadian banks of which $29,200 expires on December 1, 1994 (the short-term portion) and $36,600 expires in various amounts through December 1, 1996 (the long-term portion). The interest rate on borrowings is based on the prime rate or the "Bankers' Acceptance" rate. At August 28, 1994, no amounts were outstanding under these programs. The Company expects to renew the $29,200 short-term portion of the line of credit expiring on December 1, 1994, at substantially the same terms.
The Company has separate letter of credit facilities (for commercial and standby letters of credit), totaling approximately $193,000. The outstanding commitments under these facilities at August 28, 1994 were approximately $118,000 including approximately $53,000 in standby letters for workers' compensation requirements.
LONG-TERM DEBT
Long-term debt at August 28, 1994 and August 29, 1993 consists of:
Effective upon consummation of the Merger, PriceCostco became a co-obligor under each of the convertible subordinated debentures originally issued by Price and Costco. These debentures are convertible into shares of PriceCostco. Conversion rates of Price subordinated debentures have been adjusted for the exchange ratio pursuant to the Merger.
During the fourth quarter of fiscal 1992, Costco completed an offering of $300,000 5 3/4% convertible subordinated debentures due 2002, which are convertible at any time prior to maturity, unless previously redeemed, into shares of PriceCostco common stock at a conversion price of $41.25 per share, subject to adjustment in certain events. Interest on the debentures is payable semiannually on November 15 and May 15. Commencing on June 1, 1995, these debentures are redeemable at the option of the Company, in whole or in part, at certain redemption prices.
In fiscal 1991, Price issued $287,500 6 3/4% convertible subordinated debentures, which are convertible into shares of PriceCostco common stock at any time on or before March 1, 2001, unless
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 4 -- DEBT (CONTINUED) previously redeemed, at a conversion price of $22.54 per share, subject to adjustment in certain events. The 6 3/4% debentures are unsecured and interest is payable semiannually on March 1 and September 1. The debentures are redeemable at the option of the Company after March 1, 1994 at certain redemption prices. On November 4, 1993 notice was given to the 6 3/4% convertible debenture holders that their option to redeem the debentures, for cash equal to the principal amount plus accrued interest, in the event of a change of control of Price was effective as a result of the Merger and that holders had until December 6, 1993 to exercise such options. Approximately $2,421 of debentures were purchased at their face value subsequent to November 21, 1993.
PriceCostco also has outstanding 5 1/2% convertible subordinated debentures are convertible into shares of PriceCostco common stock at a conversion price of $23.77 per share, subject to adjustment in certain events. The 5 1/2% debentures provide for payments to an annual sinking fund in the amount of 5% of the original principal amount ($10,000), commencing February 28, 1998, calculated to retire 70% of the principal amount prior to maturity. During fiscal 1990, the Company repurchased $20,597 of the debentures for a total cost of $17,507, resulting in a gain of approximately $2,900 and will apply this purchase to the initial sinking fund payments. The debentures are unsecured and interest is payable semiannually on February 28 and August 31.
Due to the Exchange Offer, the possibility exists for a downward adjustment in the conversion price of each of the debentures. Such adjustment could occur in the event that (i) less than 21.6 million shares of PriceCostco common stock are validly tendered in the Exchange Offer and the Company distributes the remaining Price Enterprises shares pro rata to all PriceCostco stockholders or (ii) at least 21.6 million shares of PriceCostco common stock, but less than 27 million shares, are validly tendered, and the Company elects to make a pro rata distribution of the remaining shares to all PriceCostco stockholders.
At August 28, 1994, the fair values of the 5 3/4%, 6 3/4% and 5 1/2% convertible subordinated debentures, based on current market quotes, were approximately $255,000, $278,000 and $154,000 respectively. Early retirement of these debentures would result in the Company paying a call premium.
Maturities of long-term debt during the next five fiscal years and thereafter are as follows:
NOTE 5 -- LEASES The Company leases land and/or warehouse buildings at 47 warehouses open at August 28, 1994 and certain other office and distribution facilities under operating leases with remaining terms ranging from 2 to 30 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; (b) purchase of the property at the then fair market value; (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
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 5 -- LEASES (CONTINUED) been material. Additionally, the Company leases certain equipment and fixtures under short-term operating leases which permit the Company to either renew for a series of one-year terms or to purchase the equipment at the then fair market value.
Aggregate rental expense for fiscal 1994, 1993 and 1992 was $44,900, $38,700 and $33,680, respectively. Future minimum payments (including annual rents on the four Warehouse Properties discussed in Note 3) during the next five fiscal years and thereafter under noncancelable leases with terms in excess of one year, at August 28, 1994, were as follows:
NOTE 6 -- STOCK OPTIONS AND WARRANTS Prior to the Merger, Price and Costco adopted various incentive and non-qualified stock option plans which allowed certain key employees and directors to purchase or be granted common stock of Price and Costco (collectively the Old Stock Option Plans). Options were granted for a maximum term of ten years, and were exercisable as they vest. Options granted under these plans generally vest ratably over five to nine years. Subsequent to the Merger, new grants of options are not being made under the Old Stock Option Plans.
Stock option transactions relating to the Old Stock Option Plans are summarized below:
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 6 -- STOCK OPTIONS AND WARRANTS (CONTINUED) The PriceCostco 1993 Combined Stock Grant and Stock Option Plan (the New Stock Option Plan) provides for the issuance of up to 10 million shares of the Company's common stock pursuant to the exercise of stock options or up to 1,666,666 through stock grants. Stock option and grant transactions relating to the New Stock Option Plan are summarized below:
In 1986 and 1987, Price granted warrants to purchase a total of 1,065,000 shares of common stock at $17.37 per share to a joint venture partner. The warrants granted in 1987 vested over a five year period from the date of issuance and are exercisable up to eight years and one month from the grant date. A total of 532,500 warrants have been exercised.
NOTE 7 -- RETIREMENT PLANS The Company has a defined contribution retirement plan for all United States employees of Price except California union employees on whose behalf contributions are made to the Western Conference of Teamsters Pension Trust Fund. Contributions to such retirement plan totaled $11,018, $10,665 and $9,375 for fiscal 1994, 1993 and 1992, respectively. Contributions to the Teamsters Pension Trust Fund were $11,293, $11,588 and $11,196 for fiscal 1994, 1993 and 1992, respectively. During fiscal 1992, a 401(k) Plan was established for all Price employees eligible for the retirement plan. The Company matches 50% of eligible employee contributions up to a maximum Company contribution per employee per year. Contributions to the 401(k) Plan were $971, $752 and $650 in fiscal 1994, 1993 and 1992, respectively. The Company has a defined contribution plan for Canadian Price employees and contributes a percentage of each employee's salary. Contributions were $1,884, $1,640 and $1,331 in fiscal 1994, 1993 and 1992, respectively.
The Company has a 401(k) retirement plan for the benefit of all Costco employees. After one year of service, an employee is eligible to participate in this plan. Employee contributions are matched 10% by the Company until the employee has completed five years of service, at which time the matching contribution increases to 25%. Contributions were $2,677, $1,964 and $1,515 in fiscal 1994, 1993 and 1992, respectively.
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 8 -- INCOME TAXES The provisions for income taxes from continuing operations for fiscal 1994, 1993 and 1992 are as follows:
A reconciliation between the statutory tax rate and the effective rate from continuing operations for fiscal 1994, 1993 and 1992 is as follows:
The components of the deferred tax assets and liabilities related to continuing operations are as follows:
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 8 -- INCOME TAXES (CONTINUED) The net deferred tax liabilities at August 28, 1994 and August 29, 1993 include current deferred income tax assets of $54,717 and $34,901, respectively, and non-current deferred income tax liabilities of $65,679 and $51,540, respectively.
NOTE 9 -- COMMITMENTS AND CONTINGENCIES
LEGAL PROCEEDINGS
On April 6, 1992, Price was served with a complaint in an action entitled FECHT ET AL. V. THE PRICE COMPANY ET AL., Case No. 92-497, United States District Court, Southern District of California (the Court). Subsequently on April 22, 1992, Price was served with a first amended complaint in the action. The case was dismissed without prejudice by the Court on September 21, 1992, on the grounds the plaintiffs had failed to state a sufficient claim against defendants. Subsequently, plaintiffs filed a Second Amended Complaint which, in the opinion of Price's counsel, alleged substantially the same facts as the prior complaint. The case was dismissed with prejudice by the Court on March 9, 1993, on grounds the plaintiffs had failed to state a sufficient claim against defendants. Plaintiffs have filed a Notice of Appeal in the Ninth Circuit Court of Appeals, which was argued on October 4, 1994. The Company is currently awaiting a Ninth Circuit Court of Appeals decision. If the Ninth Circuit Court of Appeals renders a decision that is adverse to the Company, the Company intends to vigorously defend the suit. The Company does not believe that the ultimate outcome of such litigation will have a material adverse effect on the Company's financial position or results of operations.
The Company is involved from time to time in claims, proceedings and litigation arising from its business and property ownership. The Company does not believe that any such claim, proceeding or litigation, either alone or in the aggregate, will have a material adverse effect on the Company's financial position or results of operations.
NOTE 10 -- RELATED PARTY TRANSACTIONS Joseph Kornwasser, a director of PriceCostco until July 28, 1994, is a general partner and has a two-thirds ownership interest in Kornwasser and Friedman Shopping Center Properties (K & F). K & F was a partner with Price in two partnerships. As of August 28, 1994, Price's total capital contributions to the partnerships were $83,000. Aggregate cumulative distributions from these partnerships were $14,300 at August 28, 1994. Price had also entered into a Development Agreement with K & F for the development of four additional properties. As of August 28, 1994, Price's total capital expenditures for these properties were $58,000. Aggregate cumulative distributions from these properties were $4,500 at August 28, 1994. Both partnership agreements and the Development Agreement provided for a preferred return to Price on a varying scale from 9% to 10% on its invested capital after which operating cash flows or profits are distributed 75% to Price and 25% to K & F. On August 12, 1993, Mr. Kornwasser became Chief Executive Officer and director of the REIT. On that date, the REIT also obtained the right to acquire certain of the partnership interests of K & F described above. On August 28, 1994, the Company purchased both K & F's interests in the two partnerships and its rights under the Development Agreement for a total of $2.5 million.
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 11 -- GEOGRAPHIC INFORMATION The following table indicates the relative amounts of total revenue, operating income and identifiable assets for the Company during fiscal 1994, 1993 and 1992:
NOTE 12 -- QUARTERLY FINANCIAL DATA (UNAUDITED) The tables on the next two pages reflect the unaudited quarterly results of operations for fiscal 1994 and 1993.
All information has been restated for discontinued real estate operations and various reclassifications have been made to conform Price and Costco's classification of merchandise costs and selling, general and administrative expenses. Shares used in the earnings per share calculation fluctuate by quarter depending primarily upon whether convertible subordinated debentures are dilutive during the respective period.
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
PRICE/COSTCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Price/Costco, Inc.:
We have audited, in accordance with generally accepted auditing standards, the financial statements included in Price/Costco, Inc.'s annual report to stockholders included in this Form 10-K, and have issued our report thereon dated November 14, 1994. As noted in our report to the accompanying financial statements, The Price Company and subsidiaries (Price) have been audited by other auditors whose report thereon has been forwarded to us and our opinion expressed herein, insofar as it relates to the amounts included in the accompanying schedules related to Price for fiscal 1993 and 1992, is based solely on the report of the other auditors. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules of Price/Costco, Inc. listed in Part IV, Item 14 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
Arthur Andersen LLP
Seattle, Washington November 14, 1994
SCHEDULE I
PRICE/COSTCO, INC. MARKETABLE SECURITIES--OTHER INVESTMENTS FOR THE PERIODS ENDED AUGUST 28, 1994, AUGUST 29, 1993 AND AUGUST 30, 1992 (DOLLARS IN THOUSANDS)
SCHEDULE II
PRICE/COSTCO, INC.
AMOUNTS RECEIVABLE FROM RELATED PARTIES FOR THE 52-WEEK PERIODS ENDED AUGUST 28, 1994, AUGUST 29, 1993 AND AUGUST 30, (DOLLARS IN THOUSANDS)
SCHEDULE V
PRICE/COSTCO, INC.
PROPERTY, PLANT AND EQUIPMENT FOR THE 52-WEEK PERIODS ENDED AUGUST 28, 1994, AUGUST 29, 1993 AND AUGUST 30, (DOLLARS IN THOUSANDS)
SCHEDULE VI PRICE/COSTCO, INC. ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE 52-WEEK PERIODS ENDED AUGUST 28, 1994, AUGUST 29, 1993 AND AUGUST 30, (DOLLARS IN THOUSANDS)
SCHEDULE IX PRICE/COSTCO, INC. SHORT-TERM BORROWINGS FOR THE 52-WEEK PERIODS ENDED AUGUST 28, 1994, AUGUST 29, 1993 AND AUGUST 30, (DOLLARS IN THOUSANDS)
EXHIBIT INDEX