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

Thursday, June 10, 2004

Dollar General: Is Not So General

June 10, 2004 - Street Insight

  • DG should be accumulated on any consumer weakness numbers.
  • There is still growth ahead for this retailer.
  • Operational performance is improving, margins will likely expand.

The near future will likely to present multiple buying opportunities in Dollar General that are to be taken advantage of. DG will likely to trade down in sympathy with other retailers on any indication of consumer weakness. We think that's a buying opportunity because DG business will not be impacted by a consumer weakness in fact it will likely benefit as more affluent consumers will look for bargains in DG's stores.

Dollar General reported good numbers a couple of weeks ago. The key operating indicators showed positive operating momentum. Operations have definitely turned the corner.

Dollar General operates general merchandise stores where it offers consumable basics at very low prices. DG targets low income consumers, typically in very small towns. DG's strategy is to concentrate stores (average size 6,800 square feet) in a 200-250 mile radius from its distribution centers. This allows the company to leverage its distribution centers, achieve low transportation costs (increasingly important with high oil prices), and dominate its markets. We have owned Dollar General for a long time, and it is one of the few companies that we have given multiple second chances. The reason that we have been willing to give the company the chance to work things out is that the problems that company has run into in the past were a result of its robust growth.

Over the years, DG had a very disciplined growth strategy, growing square footage about 15% a year. That growth rate has been trimmed down recently to 10% year, which is still staggering: the company plans to open 695 stores in 2004. That's nearly two stores a day. New stores are financed from internal cash flow. The company uses very little debt and has a very strong balance sheet.

Being skeptical optimists, we look at problems as opportunities. DG's major problem had to do with managing inventory, which is a must for a slim-margin retailer. The inventory problem was three-fold: ordering the right amount of inventory, having the right merchandise on hand, and shrink. The cause of the problem was that the systems the company had in place gave local store managers control over inventory management.

Dollar General's management has made all the right moves to solve the inventory problems. It has installed POS systems in every store and linked them to headquarters. Now management knows the composition of inventory at every store by SKU every day. With new inventory management systems in place, inventory management and merchandising decisions are made by seasoned professionals at company headquarters rather than by relatively unskilled store managers.

Now Dollar General can analyze sales trends at every store and deal with problems before they escalate -- a proactive approach. It utilizes a perpetual inventory management system. Merchandise for each store is loaded on an individual pallet at a distribution center and delivered to each store weekly. One truck is able to carry inventory for multiple stores at once and unload it in a very efficient way. Perpetual (continuous) inventory management also allows DG to respond quickly to changes in demand.

These investments in the inventory management systems have paid off. Inventory turnover has improved substantially. Inventory went from 119 days in 1999 to 87 days last year, and that number has improved every single quarter over past three years. Managing inventory levels becomes even more important when a company is growing rapidly since inventory consumes a lot of cash flow.

Technology will not solve all the problems. Another problem that company still faces is shrink. The company has made good improvements in this area, but still a lot of work has to be done. Latest quarter numbers were up to 3.13% vs. 3.10% last quarter. Management said shrink has decreased on an item basis, but I will need to do more research to understand their way of calculating it. Management also indicated that reduced turnover in store managers and proactively dealing with problem stores should solve the shrink problem. We do believe that the shrink problem will be resolved but it may take a while longer. Reduction in shrink will go directly to net profits.

There are several initiatives that should help to accelerate earnings growth in the long run:

  • Buying more goods from Asia. DG has established a subsidiary in Singapore that will purchase directly in Asia. This initiative should drive margin expansion for years to come.
  • Installing coolers. Coolers drive higher levels of repeat customers. The company has indicated that stores with coolers experienced higher sales growth.

The presence of coolers will allow DG to accept food stamps, thus accessing a higher share of customer wallets.

There is still strong growth ahead of this company. A large portion of DG's stores are still fairly young, so same-stores sales should be fairly robust for years to come. Growth in new stores growth should remain around 10% a year (and possibly accelerate in the coming year once shrink issues are completely resolved). Margins are likely to expand, thus driving earnings growth at mid- to high-double digits. A strong balance sheet, improving operating performance, ample future earnings growth, and attractive valuation are the reasons why DG is part of our portfolio.

Vitaliy N. Katsenelson, CFA Copyright