Wednesday, June 30, 2004

BJ's Wholesale

June 30, 2004 - Street Insight
In this market environment “cash” is one of my favorite stocks. Though it doesn’t offer good growth potential it meets two of my other criteria: it pays a dividend (low, but it is better than nothing) and it has no risk of P/E contraction. We constantly search for new stocks to add to our portfolio, but companies that hit our value-biased screens the most are financials, pharmaceuticals (heaven knows we own plenty of both) and homebuilders (we want nothing to do with them in the rising interest rate environment). However, sometimes when we get very lucky we find some interesting “odd” stocks that don’t fit well into an industry basket. We love to find those since they provide a good source of much-needed diversification. BJ’s Wholesale is one of those “odd” stocks that we are delighted to have in our portfolios. It meets all the criteria of a stock that should weather well in the difficult market that lies ahead of us. BJ’s has good earnings growth and visibility, a strong balance sheet, excellent management and an attractive valuation. We expect overall future sales growth in the 11-13% range with earnings growth of 12-15% (factoring in gradual margin improvement and stock buy back). With this projections BJ stock is cheap, trading only at 14.8 times January 2005 earnings, and eight times trailing operating cash flows. Using conservative inputs into my discounted cash flow model I get a fair value of the stock of about $40-45. BJ’s presents an excellent risk/reward opportunity: downside risk in the stock is minimal and upside is significant – it’s a very appealing alternative to cash. BJ’s is the David in a “David and Goliath” story. The Goliaths in this instance belong to two camps: the other wholesale clubs (Sam’s and Costco) and grocery stores (such as Albertson’s, Safeway and Kroger). BJ’s has created and executed a very effective strategy that puts it on a good footing to compete with both camps. Competing Against Wholesalers Costco’s main focus has always been business customers (around 70% of its sales). The company has done a wonderful job going after them. Last year Sam’s announced that it will refocus its efforts on business customers as well. BJ has wisely decided to let Costco and Sam’s have their bloodbath. It will keep serving mainly consumers (about 70% of sales). BJ operates about 150 wholesale clubs in the northeast United States. Instead of having a very few large clubs per market, Costco’s and Sam’s strategy, BJ opens somewhat smaller clubs in more rural areas (cheaper real estate), but packs a lot of clubs relatively close to each other (and thus closer to its customers). Having clubs relatively close to each other has the drawback of lower sales per square foot versus the wholesalers, but being close to customers becomes decidedly advantageous when high gas prices start influencing consumer behavior. How does BJ compete against significantly larger wholesalers? Differentiation is the name of the game. BJ is not trying to beat its cousins on price. For most products it tries to match their prices. BJ focuses on a different customer, offering a somewhat different product mix and a larger product selection. Also, wholesalers don’t have a purchasing advantage in produce and dairy since those products are purchased from local suppliers. (My approximation is that this accounts for 10-20% of sales.) BJ leverages its high sales concentration in the Northeast to get pricing from local suppliers that’s as good as the wholesalers or better. Costco has a 2.1% advantage on COGS line (Sam’s numbers are not public). But BJ gains it back with a 2.2% advantage in SG&A expenses. That comes form BJ’s lower real estate and labor costs. (INSERT Common Size TABLE HERE) Competing Against Traditional Retailers Recently BJ introduced one thousand new SKUs (500 were swapped, 500 new were added). Most don’t overlap with its wholesale cousins but this moves puts BJ into direct competition with grocery stores and general merchandisers. BJ has several competitive advantages versus the traditional retailers: Fewer and higher-demand items. An average grocery store carries around 25,000 SKUs. General merchandise retail like Target or Wal-Mart may carry five times that amount. Costco and Sam’s carry around 5,000 SKUs and BJ has about 7,500. BJ strategy in this area is to offer a little more variety than its cousins but still carry significantly fewer SKUs than grocery stores. Cereals are a perfect example: Costco carries a handful of top brand cereals, BJ caries two or three times that, while a grocery store stocks dozens of cereals. Lower SKU count provides higher efficiency in inventory management and lowers SG&A costs. Smaller portions. I cannot tell you how many times I have purchased a large package of smoked salmon at Costco (ironically I don’t belong to BJ’s – there are none here in Denver) just to see a big portion of it go bad because my family of three could not finish the whole thing. BJ has recognized that problem (evidently the eating habits of my family are not that much different from the average consumer). They created smaller packages for some perishable items (e.g., fish and dairy). Prices per pound are a bit higher than for the larger packages (which are still available) but are better than grocery store prices. Smaller portions may slightly reduce an average ticket dollar amount, but that increases club visitation frequency. Streamlined facilities. Wholesale clubs don’t have traditional warehouses. They use much cheaper cross-dock facilities, and store much of the merchandise on pallets in the stores – which thus serve as warehouses. Stocking and restocking of the merchandise done by forklifts, for the most part. This structural cost advantage is very evident in a COGS and SG&A lines in common size statements shown below. Merchandise is sold in bulk. There is no such a thing as a single roll of toilet paper at a wholesale club. Toilet paper is sold by a multiple of a dozen. Merchandise is packaged so that no weighing is required at the register (even for perishable items such as fruit and vegetables), helping speed checkout and lowering labor costs. Lower cost structure. The combination of more efficient facilities and bulk sales means that wholesalers can achieve high sales utilizing fewer employees than their grocery counterparts. This shows very clearly in a comparison of sales and net income per employee (see table below): (INSERT Sales Per Employee TABLE HERE) Additional source of income -- membership fees. They account for most of the income for wholesale clubs (true for both Costco and BJ). This opens a very different perspective on a wholesale business model: sale of merchandise covers their fixed and variable costs where membership fees drive the income growth. Member retention and acquisition is as important as driving merchandise sales growth. Better labor relations. BJ is not unionized. (Costco is partially unionized.) This gives BJ management a lot of flexibility in decision making. Grocery stores are famous for their terrible relations with labor unions and frequent union strikes. Growth strategy BJ’s growth strategy for the business has three prongs: · Opening new stores. New stores drive merchandise sales and increase the membership base. The company grows square footage about ten percent a year, financing store openings from internally generated funds. Some of the new stores cannibalize sales from existing stores, but management indicated that impact is only about 1%. · Growing same-store sales in the mid single digits. Large portion of company’s stores have been opened in the past five years, so they have not yet reached maximum operating efficiency. Growth in same store sales is likely to be robust for the foreseeable future. · Improving margins. BJ’s net income is down from 2.8% of sales in 2001 to 1.6% today. The reason is that BJ lowered its prices substantially to bring them in line with Costco in 2002. Margins are not likely to achieve 2001 level for a long time, but they should climb to 2.0% over the next several years driven by higher penetration of higher margin private brand items and higher contribution from same store sales which carry a higher margin (operational leverage), boosting EPS growth. In addition to the fundamental growth of the business, BJ’s also plans to help grow the stock price by · Buying back stock. BJ doesn’t pay a dividend. At this valuation the company would be silly to pay a dividend. Buying back stock is a much better alternative for the long run and what company has been doing. Every year over the past five years BJ has bought back stock. Last year along it bought close to $80 million worth of stock. Based on today’s market value, which is higher than last year that’s equivalent to a 5% dividend yield. BJ’s has had several special charges since 1996, but they were truly special. They resulted from the fact that BJ was spun off from Waban (which was spun off from Zaire) and was responsible for the leases of defunct House2Home. That has gradually been resolved over the past couple of years resulting in special charges. Wholesale clubs have transformed retail industry over last twenty years; they demonstrated that they are a valuable alternative and often a great substitute to grocery stores and general merchandisers. Though limited selection of merchandise at wholesale clubs still leaves a need for other avenues of retail, wholesale clubs are likely to play a larger role in retail in the future at the expense of grocery stores and general merchandisers. The future is bright for BJ’s.
Vitaliy N. Katsenelson, CFA Copyright


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