Description

· BJ’s Wholesale Club is a good business at a great price. The stock is down 70% in the last year because earnings are flat compared to 20% annual EPS growth in the last five years. It is valued at a depressed multiple of depressed earnings: 8x forward earnings, 4x EBITDA and 1.5x tangible book value. It is one of the few $1 billion plus market cap companies with a 20%-ish ROE (no debt) that can be bought at such an attractive valuation. At this price, you are buying its stores at replacement cost and getting the value of seven million members with a consistent mid-80% annual renewal rate for free.
· BJ’s is a broken growth story because of (in the order of significance): (i) the one-time penetration of 14 stores into new Southeast markets in the last 18 months where stores take longer to scale up, reducing overall margins, (ii) the economy, which is causing a mix shift away from high margin products, and (iii) increased competition (including a few examples of competitors opening up literally across the street), which has reduced same-store-sales by 1%.
· BJ’s is being offered at a bargain price because growth managers long ago discarded it and everybody else is scared off by earnings misses and mediocre same-store-sales growth. Sell-side analysts almost universally despise BJ’s despite their exuberance for other retail names at 30x earnings.
· I would like to challenge the conventional wisdom that BJ’s franchise is impaired by the expansion of competitors: (i) the major wholesale club chains (BJ’s, Costco and Sam’s) can continue to grow by taking market share from other retail formats rather than from each other because they have an unmatchable value proposition (i.e. they are structurally able to offer significantly lower prices than grocery stores and mass merchandisers), (ii) BJ’s has already competed successfully for several years in saturated markets, (iii) BJ’s is primarily a regional business with dominant market share in the Northeast and few competing stores have opened in its core markets in the last three years, (iv) while BJ’s is the smallest of the three wholesale club chains, it has the lowest cost structure and the highest margins and returns on capital, and (v) consistently high mid-80% membership renewal rates provide a barometer of competitive strength.
· The biggest negative is management’s insistence on expanding square footage 10% per year, which may reduce returns-on-capital going forward. I’ve gotten comfortable with this by modeling a decline in ROE from 22% to 12% over the next 5-10 years and doing a DCF. I think this is a conceivable downside scenario and that the current price is still reasonable.

Business Overview
· BJ’s is the smallest of the three major wholesale club chains with 144 stores and 6.9 million members (vs. Costco: 345 stores/40 mm members and Sam’s: 500 stores/46 mm members). BJ’s is also one of the few remaining regional retailers, with 60% of its stores in five northeast states.
· Wholesale clubs have been one of the most attractive areas of retail in the last 10 years, growing at twice the rate of the retail industry overall by under-pricing grocery stores and mass merchandisers. On a per unit basis, BJ’s prices are 40% lower than grocery stores and 16% lower than Wal-Mart (BJ’s merchandise mix is roughly 60% groceries/40% general merchandise).
· Wholesale clubs are structurally able to offer low prices because: (i) they charge an annual membership fee which offsets low merchandise margins (BJ’s gross margin is half that of Wal-Mart and grocery stores); (ii) they have faster inventory turns and asset turns because they carry 10% of the SKUs found at a grocery store, typically the most popular items, and because they operate a “no-frills” environment; (iii) SG&A expense is roughly 40-50% of a grocery store or mass merchandiser because of cheaper locations, minimal advertising, less service and non-union labor.

Valuation and Financials
· BJ’s is a “broken growth story” and is currently trading at its lowest valuation since going public in 1997. BJ’s grew memberships, sales and earnings 10%, 12.5% and 20% per year, respectively, in the five years through 2001, but the stock price fell 65% in 2002 due to a series of earnings disappointments. BJ’s is expecting EPS of $1.93 in 2002 (down from a high estimate of $2.22) and $1.90 in 2003 (down from $2.56). Management recently said the $1.90 estimate for next year would be tough to achieve. The most negative analyst estimate for 2003 EPS is $1.71, reflecting additional gross margin erosion. This implies an 8x forward P/E multiple.
· The deterioration in earnings is due to three factors: (i) new store productivity has been below historical levels because BJ’s is increasing the percentage of clubs opened in new markets, which take longer to ramp up, (ii) the slowdown in consumer spending has caused calendar 2002 comp store sales to be 1.9% versus plan of 3-5%, with a negative effect on operating leverage, and (iii) BJ’s is facing increased competition from other wholesale clubs, which has reduced comp store sales by 1%.
· Over the last five years BJ’s has traded at an average of 19.2x forward earnings, and at a 30% discount to Costco on a P/E basis. BJ’s currently trades at 8x 2003 earnings (a 55% discount to Costco’s forward P/E of 18x) 4.0x EBITDA, and 1.5x tangible book value. BJ’s enterprise value per square foot (assuming operating leases are capitalized) of $150 is half that of Costco while EBITR (EBIT before occupancy costs) per square foot is roughly the same for both companies at $21-23. Finally, BJ’s enterprise value per store of $16 million is close to the replacement cost of $15 million per store.
· The economics of BJ’s business are attractive, generating an estimated 21% ROE in 2002 with virtually no debt (although it has operating leases on most stores). In addition, BJ’s margins and returns on capital are slightly higher than Costco’s. Based on management’s guidance, I assume ROE will decline to the 17-18% range in 2003.

Competition
· BJ’s competition should be viewed broadly as grocery stores and mass merchandisers because most of the growth in wholesale clubs has been achieved by taking market share from these categories. Wholesale clubs’ market share in groceries grew from 2% in 1990 to 9% in 2001, with considerable regional variation. In many of BJ’s core northeast markets, wholesale club share is 6% vs. 15% in California markets where penetration is highest, so there is still meaningful share gain potential. In the last five years, Wal-Mart’s share of the grocery market has doubled from 5% to 10%. The losers are the grocery stores. Alberston’s, Kroger and Safeway have each lost market share in the last five years, and the smaller independent chains that account for one-third of the market are doing even worse.
· Most analysts agree that wholesale clubs will continue to grow in the high single digits for the next five years until the market is saturated. The saturation point is estimated at 1,150 to 1,300 stores vs. 920 stores today, or absolute growth of 25-40%. This represents one club per 225,000-250,000 Americans, which compares with one Wal-Mart, Target or K-Mart per every 50,000 Americans currently.
· 90% of BJ’s stores are within 10 miles of one wholesale club competitor and 50% are within 10 miles of two competitors, so BJ’s has already been competing successfully on a head-to-head basis. BJ’s name is synonymous with wholesale clubs in the northeast, where it is the oldest chain and still has 50% market share (BJ’s other primary markets are Florida with 38% share and the mid-Atlantic with 32% share). Its membership renewal rates have held steady in the mid-80% range, except for a 2% decline in 2001 following an increase in the membership fee from $35 to $40, which was a net positive.
· BJ’s is not facing significant new competition in its core regions. 60% of BJ’s stores are in five states (NY, MA, FL, NJ and PA). In the last three years Sam’s has opened two stores in these states and Costco has opened seven. At the same time, BJ’s has actually increased its store share in these markets.
· BJ’s differentiates itself from Costco and Sam’s by focusing on individual retail consumers as opposed to small businesses. Accordingly, BJ’s is more like a “grocery store on steroids” because it has 50% more SKUs and smaller package sizes than its competitors, and it accepts credit cards. Note that if Costco were to accept major credit cards it could face a 1% hit to its gross margin from the fees.
· Costco’s comp store sales have been an average of 3% higher than BJ’s over the last five years, but this needs qualification. Costco is indeed a better mouse-trap, but: (i) Costco has more stores in non-competitive markets, (ii) Costco owns the ancillary businesses in its stores, such as food courts, optical centers and photo centers, while BJ’s leases this space, which accounts for 1-1.5% of the comp store gap, and (iii) BJ’s store clustering strategy (see below) is self-cannibalizing.
· BJ’s also differentiates itself by clustering slightly smaller stores in suburban rather than metro areas. In part because its rents are lower, BJ’s stores are “nicely profitable” at the $30 million sales level vs. $44 million average sales per store (Costco’s sales-per-store is twice that of BJ’s). In Westbury, NY, for example, Costco has one of its best stores with $200 million in revenue in a central “A” location, while BJ’s has four stores each with $50 million in sales in outlying areas. This clustering strategy has enabled BJ’s to obtain leading market share in most of its markets and to prevent competition from entering.

Catalyst

BJ’s is a good business at a great price.
BJ’s bought back 12% of its shares in the last five years and has $94 million remaining under its existing buyback plan, which is equal to 9% of its shares at current prices.
BJ’s is a potential acquisition target because of its valuable real estate in the northeast. Wal-Mart has been mentioned as a potential acquirer as well as European hypermarket retailer Carrefour.