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BJ's Wholesale Club, Inc. (NYSE:BJ)

F2Q09 Earnings Call

August 19, 2009 8:30 am ET

Executives

Cathy Maloney - Vice President, Investor Relations

Frank Forward - Chief Financial Officer

Laura Sen - President and Chief Operating Officer

Herb Zarkin - Chairman and Chief Executive Officer

Analysts

Bob Drbul - Barclays Capital

David Schick - Stifel Nicolaus

Daniel Binder - Jefferies & Co.

Neil Currie - UBS

Robert Ohmes - Banc of America

Mark Wiltamuth - Morgan Stanley

Laura Champine - Cowen & Company

Peter Benedict - Robert W. Baird

Adrianne Shapira - Goldman Sachs

Nathan Rich - Citigroup

Operator

Please stand by. Good morning and welcome to the BJ's Wholesale Club Incorporated second quarter earnings results conference call. There will be some formal remarks made by the company and then we will open up the call for questions.

At this time, I would like to turn the call over to Cathy Maloney, Vice President of Investor Relations.

Cathy Maloney

Thank you, Mark. With me this morning are Laura Sen, President and CEO; and Frank Forward, Chief Financial Officer.

Before we begin, let me remind everyone that the discussions we are having include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements involve risks and uncertainties that may cause actual results, events, and our performance to differ materially from those indicated by such statements. The risks and uncertainties include, but are not limited to, levels of gasoline profitability, levels of customer demand, economic and weather conditions, federal, state, and local regulation in the company’s markets, federal budgetary and tax policies, litigation, competitive conditions, and other factors discussed in the company’s most recent annual report, which is on file with the SEC.

Forward-looking statements represent our estimates only as of today. While the company may elect to update its forward-looking statements, the company specifically disclaims any obligation to do so, even if the company’s estimates change.

And now I will turn the call over to Frank Forward.

Frank Forward

Thank you, Cathy. Good morning, everyone. For the second quarter ended August 1, 2009, net income was $35.1 million, or $0.54 per diluted share. Comparatively, for last year’s second quarter ended August 2, 2008, net income was $36.5 million, or $0.61 per diluted share.

Last year’s second quarter results included [inaudible] income of $2 million, or $0.03 per share, related to favorable tax, income tax audit settlement.

Adjusting for last year’s unusual item on a non-GAAP basis, EPS was $0.64 per share this year versus $0.58 per share last year, a 10.3% increase, and net income was $35.1 million this year versus $34.5 million last year, an increase of 1.7%.

For the first half of 2009, net income was $59.4 million, or $1.09 per diluted share, and for the first half of 2008, net income was $53.7 million, or $0.90 per share. Last year’s first half results included the post-tax income of $2 million, or $0.03 per share related to the state income tax audit settlements.

Adjusting for the unusual item last year, on a non-GAAP basis first half EPS was $1.09 per share this year versus $0.86 last year, a 26.7% increase, and net income was $59.4 million this year versus $51.7 million last year, an increase of 15.0%.

Our second quarter sales were unfavorably affected by unseasonably cool and wet weather in the Northeast, weak consumer spending, and increased price deflation, particularly in some perishable departments such as dairy, milk, meat and produce.

Despite these top line challenges, our earnings beat the midpoint of our guidance range of $0.60 to $0.64 per share by $0.02 per share, primarily due to the higher than planned merchandise margin rates, strong gasoline profitability, and good control of public expenses.

Also worth noting is that Q2 comp traffic remained strong at 4%, and we continue to see good unit sales growth, both of which are encouraging signs of increased market share.

Total sales for the second quarter were $2.51 billion, compared to $2.64 billion last year, a decrease of 5.2%. This was unfavorably affected by gasoline sales that were about 52% below last year. Second quarter comparable club sales decreased by 7.7%, which included an unfavorable impact from gasoline sales of 10.6%.

Comparable merchandise sales excluding gasoline increased by 2.9%, which was lower than our guidance of 4% to 6%, again primarily due to the weather and deflation issues I mentioned earlier.

Next, our breakout comp club sales by major market, including the impact from sales of gasoline. There will be five columns. I will begin with the region and read across four more columns, beginning with Q2 comp sales, then Q2 gasoline impact, then first half comp sales, and then Guitar Hero gasoline impact.

New England, negative 7.3%; negative 10.1%; negative 4.5%; negative 9.4%.

Upstate New York, negative 14.7%; negative 15.8%; negative 11.1%; negative 15.2%.

Metro New York, 2.5%; negative 2.1%; 4.5%; negative 1.9%.

[inaudible], negative 8.9%; negative 10.2%; negative 6.1%; negative 9.4%.

Southeast, negative 14.8%; negative 17.1%; negative 11.0%; negative 16.0%;

And total comp, negative 7.7%; negative 10.6%; negative 4.8%; and negative 9.8%.

[inaudible] of gasoline, second quarter [inaudible] in the average transaction [inaudible]

approximately 5% transaction [inaudible] for the full year.

We estimate that given the [inaudible]

[Technical Difficulties]

-- as well as increases in comp sale dollars, although at a lower rate of growth than in the first quarter.

Departments with strong second quarter sales included candy, cereal, cigarettes, computer equipment, dairy, deli, fresh meat, frozen, health and beauty aids, household chemicals, ice cream, paper products, pet foods, produce, snacks, and television.

Departments with weakest second quarter sales included air conditioners, apparel, domestics, electronics, jewelry, juices, lawn and garden, milk, oil and shortenings, pre-recorded video, sporting goods, summer seasonal, tires, trash bags, and [inaudible].

Now let me go through the second quarter income statement detail -- MFI increased by 2.0% in dollars versus last year; other revenue decreased by 0.6%; cost of sales, including buying and occupancy, decreased by 115 basis points. SG&A expense increased by 98 basis points, and pre-opening expense was $3.8 million, versus $0.1 million last year.

And now for the details -- second quarter MFI grew 2.0% versus last year. This is an increased rate relative to the 0.8% growth in the first quarter. This ramped up MFI growth reflects both the deferred recognition of increases in cash MFI from higher renewals, and the benefit from opening more new clubs earlier this year as compared to 2008.

Second quarter renewals were essentially on guidance and the full year renewal rate appears to be tracking towards an increase of about 0.5% to 1% versus last year, or about 1%, or 0.5% ahead of our original plan.

We are pleased with very strong new membership sign-ups at our new clubs in Pelham, New York; Clearmont, Florida; and Bronx, New York. Each of these clubs exceeded their plan; however, new member sign-ups in comp clubs remain a challenge. In Q2, they ran slightly below last year.

Cost of sales as a percent of sales decreased by 115 basis points due to the following -- decreased sales of low margin gasoline at a favorable mix impact of about 115 basis points versus last year. The profits from gasoline was about $0.01 per share below LY. However, gasoline prices fluctuated enough in the second quarter that the profits from gasoline was about $0.03 per share above guidance.

Merchandise margins, excluding gasoline, increased 46 basis points versus last year, which reflects a mixed benefit from increased sales of high margin perishables, lower freight expense due to reductions in fuel costs, and the benefits from operational improvements that have reduced shrink and salvage costs. These factors were partly offset by buying and occupancy expense, which increased 45 basis points versus last year, due primarily to expense deleveraging from lower gasoline sales.

SG&A expense increased 98 basis points versus last year due to the following -- SG&A expense experienced deleveraging due to gasoline sales that were significantly below last year. Perhaps a better way to look at it -- SG&A expense dollars increased 7.1% versus last year as compared to a 9.2% increase in the first quarter.

Growth in SG&A expense dollars versus last year was primarily driven by increases in club payroll, medical inflation, and IT roadmap costs.

The percent growth in SG&A expense was lower in Q2 than in Q1, partly due to Q2 having a more favorable LY comparison for gasoline credit costs, which rose significantly in Q2 last year as gasoline retail prices increased.

We continue to invest in club payroll, particularly in the perishable areas, to maintain service levels and club conditions, and like many companies, we continue to see significant increases in medical costs.

Finally, the investment in the road map technology project was a post-tax expenses of $1.2 million, or $0.02 per share, or about $0.01 per share above last year. Pre-opening expense was $3.8 million this year, versus $0.1 million last year, or about $0.04 per share above last year. This reflected spending on three new clubs that opened in Q2 this year versus one new club in Q2 last year.

We also incurred pre-opening expense in Q2 for a club in North Burgan, New Jersey that opened this past weekend.

Interest was $0.1 million of expense this year versus $0.5 million of income last year. The income tax rate for the second quarter was 40.6%, versus 37.3% last year. Last year’s second quarter included a benefit from favorable tax, income tax audit settlements. Excluding this benefit, last year’s tax rate was 40.7%, or approximately the same as last year.

Moving to the balance sheet, average inventory per club at the end of July increased by 3.8% versus last year, due to softer-than-expected sales in the last two weeks of the month, particularly in edible grocery and consumables. However, the inventory sold through well in the first two weeks of August as sales results improved.

Underneath all this, inventories are in very good shape but we do not see any significant markdown exposure.

The accounts payables inventory ratio at the end of the first quarter was 70.4% versus 73.0% last year. The payables ratio was unfavorably affected by about 4% versus last year due to significantly lower gasoline sales, which have high inventory turns. The merchandise payables ratio excluding gasoline was slightly above last year.

In Q2, we did not purchase any stock in the open market. As of August 1, 2009, we had approximately $138 million remaining for stock buy-backs under existing board authorization.

We ended the second quarter with cash of $37 million and no short-term debt, versus cash of $116 million and no debt last year. The increase in cash, the decrease in cash versus last year is principally due to the approximately $153 million of share repurchases we made in the past 12 months.

Now I will turn the call over to Laura.

Laura Sen

Good morning, everyone. Thank you for joining us today. I would like to lead off my discussion of the second quarter with a review of our strong chain growth and positive membership trends. Chain expansion is key to our growth strategy. We plan to open seven new clubs this year compared to four new clubs last year. During the second quarter, we opened a new club in Claremont, Florida, as well as two clubs in the metro New York market, one in Pelham Manner and the other in Bronx terminal market.

We have high expectations for membership and sales volumes in the two metro New York clubs based on the population density of their trade areas and so far, we are very pleased with the enthusiastic response we have seen from the surrounding communities.

Our fourth new club of the year, located in North Bergen, New Jersey, had its soft opening last weekend and will grand open this weekend. Additionally, we are on track to open three more clubs this year including our first 85,000 square foot prototype, which will be located in Quaker Town, Pennsylvania. The two other clubs will be located in Oaks, Pennsylvania, and Flushing, Queens. We expect to open the two Pennsylvania clubs before the Christmas holiday season and the Flushing, New York club in January.

We continue to see positive membership trends during the second quarter, with renewals tracking slightly ahead of plan for the year and an increase in sign-ups of rewards members versus last year. As a reminder, rewards members pay an $80 membership fee instead of $45, which makes them eligible to earn up to $500 a year in merchandise credits known as BJ's bucks.

We were pleased with the results of our annual spring member acquisition program, which ran from late March through early July. Compared to last year, we saw an increase in trial membership, as well as trial related spending and among new paid members, we saw increases in both average ticket as well as frequency compared to last year.

So what’s driving these results? While it’s clear that our everyday low prices are a draw for consumers trying to stretch their budgets, I believe that our investments in merchandising, club renovations, technology, and club operations are paying off in higher levels of member satisfaction.

As Frank said in his comments, second quarter earnings came in at the high-end of guidance, due to a combination of higher merchandise margins, better-than-expected gasoline profitability, and strong expense control. The increased penetration of high margin perishable foods was an important component of our merchandise margin expansion during the quarter. Strong comp sales growth in food and consumables and our consistently strong traffic increases also demonstrate that we are making good progress in capturing a larger share of our members’ weekly food budget. Despite significant price deflation in a number of high velocity departments, comparable club sales of food increased by 6% on top of a 10% increase in last year’s second quarter. In perishables, where we saw accelerating rates of price deflation in meat, produce, milk, eggs and dairy, comp sales increased by approximately 6% on top of a 12% increase in last year’s second quarter.

Our member traffic excluding gasoline sales increased by 4%, our sixth consecutive quarter of strong traffic increases. Our strong expense control during the quarter was driven by operational efficiencies in merchandising, club operations, IT, loss prevention and logistics.

We have a lot to be proud of in this area. Our achievements reflect an extraordinary level of collaboration and cooperation among key members from many departments and geographies. The message here is that when our team members share a common vision, they can accomplish great things even under challenging conditions.

I would like to give you five examples of operational efficiencies that contributed to our results. First, we continue to build proficiency in our processes for ordering and replenishing perishable foods. Our presentations have improved significantly and we have reduced shrink and salvage, resulting in better freshness for our members every day.

Second, our loss prevention team achieved a substantial savings in shrink reserves during the first half through the implementation of new processes and procedures. What makes this even more impressive is that BJ's already has one of the lowest shrink levels in retail, less than 25 basis points of net sales, and our loss prevention team achieved similar results in last year’s first half.

Third, we improved operational efficiencies in distribution by implementing the -- by completing the implementation of a new warehouse management system at our Jacksonville, Florida [inaudible]. The new system, which is now fully operational at all of our three distribution centers, helps us accelerate inventory flow to the clubs and gives us better visibility of our inventory.

Fourth, we made good progress with the transition to new data center provider with a selection of [Witpro] Technologies as our business processing partner. The strategic relationship will allow BJ's to leverage Witpro’s global infrastructure management experience and IT best practices.

And last, as Frank said in his comments, general merchandise sales decreased by 2% for the second quarter, reflecting weak consumer spending on discretionary items, particularly in jewelry, apparel, electronics, and sporting goods. It was no small accomplishment that we ended the quarter with a lower level of seasonal markdowns versus last year and very clean inventories. I am very proud of the excellent teamwork between our buyers, replenishment specialists and logistics teams that brought about these results.

Now I will turn the call back to Frank to review our outlook for the second half.

Frank Forward

Thanks, Laura. Before getting into the details of our guidance, I would like to make a few comments on our planning assumptions. We think the softening of sales trends in Q2 reflected unseasonably cool and rainy weather in the Northeast. Our weaker-than-expected macroeconomic environment and a greater-than-expected unfavorable impact from deflation.

Looking forward, we believe deflation will continue to be a headwind in Q3 and for part of Q4 when we expect to start to cycle it, and we believe consumer spending will continue to be restrained through this year’s holiday season.

The second quarter moderation in sales and the impact of deflation have made us more cautious and we now believe that it is prudent to lower our second half merchandise comp sales guidance to a range of 3.5% to 5.5%, as compared to our prior guidance of 5% to 7%.

In Q3, we are planning merchandise comp sales at 3% to 5%, which includes our best estimate of the impact of deflation. This is stronger than our second quarter results, which were unfavorably impacted by weather. In fact, sales for the first two weeks of August have improved as we experience more seasonable weather.

And in Q4, we expect to start cycling some of the deflation and are now planning for the merchandise comp sales increases in the 4% to 6% range.

For earnings, we are increasing our full year guidance to $2.46 to $2.56 per share versus our prior guidance of $2.44 to $2.54 per share. This reflects beating the midpoint of the second quarter guidance range by $0.02 per share and holding to our prior guidance for the second half.

We are holding to the second half earnings guidance despite lowering sales because we now expect our merchandise margins to run favorable to plan for the remainder of the year. This reflects greater-than-expected benefits from operational enhancements in a number of areas but particularly in perishables, and we expect some incremental margin benefit from continued deflation effects in certain categories and from lower fuel costs.

However, I should also mention that even with these margin increases, we are not planning second half merchandise margin rate increases to be as strong as what we achieved in the first half.

In Q3, we face comparisons to strong 2008 margin rates, driven by buy-ins to counteract inflation and in Q4, we expect continued soft sales in the higher margin categories of general merchandise to create an unfavorable mix impact.

And now I will get into the detailed guidance -- in the third quarter, we are planning for total sales in the range of a decrease of 1.4% to an increase of 0.6%, driven by comparisons to last year’s very strong sales of gasoline. Comp sales to decrease in the range of 3.5% to 5.5%, including an unfavorable impact from gasoline sales of 8% to 9%. Comp merchandise sales excluding gasoline to increase 3% to 5%.

However, within Q3, we don’t expect an even flow of merchandise comp sales by month. August will be unfavorably affected by 2% by a calendar shift of the Labor Day holiday and by about 0.8% from the cancellation of a sales tax holiday in Massachusetts. As a result, we are planning August merchandise comp sales to be in the range of flat to an increase of 2%. September will benefit by about 1.5% from the Labor Day shift and from comparisons to soft sales for several weeks after the stock market crash last year.

As such, we are planning September merchandise comps to increase in the range of 5.5% to 7.5% and we are planning October in the range of 3% to 5% increase.

Membership fee income to increase about 2.5% to 3.5% in dollars, driven by the impact of new club openings and by increases in renewal rates. Other revenue to increase by 7% to 8%. Cost of sales to decrease in the range of 11 to 21 basis points. This assumes a favorable margin mix impact from the decreased sales of lower margin gasoline and the higher merchandise margin rates. These factors are planning to be partly offset by unfavorable deleveraging of buying and occupancy costs due to lower gasoline sales. A favorable mix impact of lower margin gasoline sales is planned to be about 40 to 50 basis points versus last year, which is less favorable than the approximate 110 basis point benefit from the first half because by October, we start to cycle the drop in gasoline prices last year.

Merchandise margin rates are planned to increase 15 to 25 basis points. This increase is less than the mid-40 basis point increase during the first half due to comparisons to strong margins in Q3 last year from buy-ins, but this is stronger than our prior guidance due to the operational deflation and fuel cost margin benefits mentioned earlier.

SG&A expense as a percent of sales is planned to increase 40 to 50 basis points versus last year. The planned Q3 increase is less of an increase than in the first half, due to less expense deleveraging as we start to cycle last year’s drop in gasoline prices. We also expect SG&A dollars in Q3 to grow by about 4.3% to 5.3% versus last year, due to continued investment in club payroll and roadmap technology initiative. This is less than the approximate 8% increase seen in the first half, partly due to last year’s SG&A, including some non-recurring severance, bonus, and sales tax audit settlement costs. In addition, gasoline credit card costs are expected to be lower as we compare to high gasoline prices last year.

The roadmap costs are primarily included in SG&A and are planned to be about $0.04 per share in Q3 as compared to $0.02 per share last year.

Pre-opening expense is planned in the range of $2 million to $2.5 million, versus $1.0 million last year, an increase of about $0.02 per share. An income tax rate of 40.6% versus last year’s 39.8% rate, interest expense of $0.2 million versus income of $0.2 million last year.

And finally, Q3 earnings on a GAAP basis of $0.43 to $0.47 per share and net income of $23.7 million to $25.7 million. This compares to last year’s GAAP earnings of $0.48 per share and net income of $28.2 million.

Last year’s Q3 earnings included unusual expense of $0.5 million post-tax, or $0.01 per share, related to club closing costs. Last year’s results also included non-reoccurring items composed of extraordinary levels of gasoline income, partly offset by the previously mentioned non-reoccurring expenses of severance, sales tax audit settlements, and gasoline related bonus accruals. These items netted to an income of $5.8 million post tax, or $0.10 per share.

We think the best way to view our third quarter guidance is to compare it to last year on a non-GAAP, normalized basis, adjusting for both the unusual expense and the net non-reoccurring income. On this basis, the midpoint of our Q3 guidance of $0.45 per share will be about a 15% increase versus last year’s $0.39 per share and post-tax net income will be $24.7 million this year versus $23.0 million last year, a 7.5% increase. These results also include the increases in pre-opening and roadmap costs, which unfavorably affect earnings growth by approximately 7%.

For the fourth quarter, we are planning for total sales to increase in the range of 8.5% to 10.5%, due to cycling last year’s drop in gasoline prices and the benefit from this year’s earlier new club openings. Comp sales to increase 4% to 6%, including an impact from gasoline sales in the range of 1% decrease to a 1% increase. Comp merchandise sales excluding gasoline are planned to increase 4% to 6%. This assumes food sales strengthen relative to Q2 and Q3, as we start to cycle some of last year’s deflation in the fourth quarter. However, we are assuming continued soft general merchandise sales in Q4 due to a weak economy.

MFI to increase 3% to 4% in dollars, driven by new club openings and strong renewal rates. Other revenue to increase 10% to 12%. Cost of sales percent to decrease 7 to 17 basis points. This reflects less margin improvement than during the first half of this year, primarily due to assuming an unfavorable mix impact from low margin gasoline sales as we cycle last year’s big drop in gasoline prices.

Merchandise margins excluding gasoline to increase 23 to 33 basis points. This increase is partly driven by the high level markdowns taken during last year’s weak holiday season. This year, we are planning our inventories more conservatively going in and expect markdowns to be less significant than last year.

SG&A as a percent of sales to increase 18 to 28 basis points, which is less of an increase than in the first half. This primarily reflects the cycling of the GAAP deleveraging, partly offset by costs from opening high volume new clubs and the increased roadmap technology investment. The Q4 roadmap investments are planned to be about $0.04 per share this year versus $0.01 per share last year.

SG&A dollars to increase in the range of 11.5% to 13.5%, driven by the increased roadmap costs and the impact of opening new clubs. Pre-opening expense to be about $1.2 million to $1.6 million, versus $2.1 million last year. Interest expense to be about $0.2 million, and an income tax rate of 40.6%.

And finally, we are planning for Q4 earnings on a GAAP basis in the range of $0.96 to $1 per share, and net income of $52 million to $54 million. This compares to last year’s GAAP earnings of $0.91 per share and net income of $52.7 million.

Last year’s Q4 earnings included unusual income related to favorable tax audit settlements of $1.3 million post tax, or $0.02 per share. On a non-GAAP basis, using the midpoint of our guidance and adjusting last year for the unusual income, the comparison will be $0.98 per share this year versus $0.89 per share last year, an increase of about 10%. And post-tax net income will be $53 million this year versus $51.3 million last year, an increase of about 3%. These results include combined roadmap and pre-opening expenses that are planned to be a net of $0.03 per share higher than last year, which unfavorably affects EPS growth by about 2%.

And so for the full year, we are planning for total sales to be in the range of 0.5% to 1.5% increase, comp sales to decrease 1% to 3%, including 6% to 8% unfavorable impact from gasoline sales, and comp merchandise sales excluding gasoline to increase 4% to 6%.

MFI to increase 2% to 3% in dollars, other revenue to increase 4% to 6%, cost of sales percent to decrease 65 to 75 basis points, SG&A as a percent of sales to increase 55 to 65 basis points, SG&A expense dollars to increase 8% to 9%, pre-opening expense to be about $8.5 million to $9.5 million. Interest expense to be about $0.5 million to $1 million, an income tax rate of 40.6%. Capital expenditures to be in the range of $180 million to $200 million. We expect to be capital self-sufficient in 2009 and generate net cash from operating activities of about $240 million to $280 million, and we expect share repurchases to be about $100 million, $70 million of which we repurchased in the first quarter.

And finally, based on all this, we expect earnings on a GAAP basis to be in the range of $2.46 to $2.56 per diluted share, and net income of $134 million to $140 million. For 2008, full year GAAP EPS of $2.28 per diluted share included $0.05 per share of income from unusual items, comprised of $0.06 per share of favorable state income tax audit settlements, less $0.01 per share expense from a club closing at reserve.

The 2008 results also included the $0.10 per share of non-reoccurring income from Q3 that was discussed earlier. So on a non-GAAP normalized basis, excluding both the unusual items and the non re-occurring income, the 2008 earnings will be net income of $126 million or $2.14 per share.

Using the midpoint of guidance for 2009 and using the non-GAAP normalized earnings for 2008, the comparison would be EPS of $2.51 per share versus $2.14 per share last year, an increase of about 17% and for net income, it would be $137 million in 2009 versus $126 million in 2008, an 8.7% increase.

For the year, we are planning the combined roadmap and pre-opening investments to be a total expense of about $12 million post tax, or $0.22 per share. This compares to about $5 million post-tax, or $0.08 per share last year. This unfavorably affects earnings growth by about 5%.

And with that, I will now turn it over to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question today comes from Bob Drbul with Barclays Capital.

Bob Drbul - Barclays Capital

Good morning. I guess the first question that I have is when you talk about the food deflation that is going on, can you just help us understand how you are managing profit dollars? I think you did a good job explaining the comp dollars but I was wondering if you could just help us understand exactly how those comp dollars for those items that have the deflation that’s increasing within the mix?

Laura Sen

Well, I think that the governing principle that will hold on all of our pricing is being priced at strong value for our members and at a competitive price with -- [inaudible] competitors and where we don’t have items that compete against grocery or a super center, we want to make sure that we are offering a very strong value in all cases, so I guess in short there are cases, and we’ve seen it in meat, we’ve seen it in gasoline as well, where when prices -- when costs of goods drop, sometimes competition chooses to hold retail a little higher than they might otherwise do it and that benefits us and we will follow rather than lead down. So that’s a help to gross margins but in many cases, the commodities where we have seen deflation are extremely competitive, like milk and eggs, and those prices drop very rapidly as costs drop and that doesn’t really offer us a lot of advantage, so -- the dynamic is very fluid and it depends on the category, and I think that a lot of times we as retailers, whether it’s for the category of meat or other categories, look at what is offering the strongest value and if there’s some margin opportunity, we like to take it but when all is said and done, we have to be very competitive and make sure that we are holding to our promise of great value when we sell a membership.

Bob Drbul - Barclays Capital

Great, thanks. And then the second question that I have is can you elaborate a little bit more on the trend in August and really what you have seen after the last few months, especially just July into August?

Laura Sen

Well, I mean, what Frank said was what we have seen, is we have had some incredibly tough weather in most of our geography and when it got to be summer as we know it, trends go better. And that’s really all we can say for now.

Bob Drbul - Barclays Capital

Thank you very much.

Operator

Your next question comes from David Schick with Stifel Nicolaus.

David Schick - Stifel Nicolaus

Good morning. A question on what you think is the dynamic around the renewals and new clubs and existing -- so if I go back, renewals are getting better and new clubs you are very pleased with, but the existing club, new member sign-up is a little worse. Just sort of wanted to know what you think is the dynamic driving all of that?

Laura Sen

A new club, existing club new members are somewhat affected by new club openings because we are opening in similar geography as our current clubs, as you know, so there’s a little bit of that. But I would also point to the fact that the majority of our MFI dollars are driven by renewal. It’s 80% of the income is going to come from that and the new clubs bode very well for our future because obviously those are going to have -- that’s where the growth will come from.

Frank Forward

I would imagine, Dave, some of the weakness in the new members is just an economic issue. Getting people into -- you know, we’ve been very successful getting people to come in off of the trials and again, when we can get them in and kick the tires, we do a pretty good job of converting them. But I am sure there is a little issue with the economy making that. But again, like Laura says, the vast majority of our -- of the dollars in MFI is coming off our renewals.

David Schick - Stifel Nicolaus

Great, thanks. And just a sort of housekeeping question, Frank -- you guys did a great job giving us the sort of pennies per share on roadmap and you’ve done that in the past but is there anything changing in your view of how roadmap plays out from 30,000 feet over this year and the next and just sort of talk about that on the cost side and timing of costs?

Frank Forward

Sure. We are obviously watching the process very carefully. It’s a big deal for us. We think we are going to get a lot of benefits out of this process over time. I think lessons learned over the course of the last quarter are one of -- we’ve got to take everything probably a little slower, not a lot so -- but I don’t think the cost changes are going to change much. We have certainly done a lot of work looking at next year at this point in time. We are not ready to talk much about it. We still have some decisions to make. We are still going through -- the largest project right now is the data conversion process to Witpro and that is scheduled to be implemented probably March, April, at worse May of next year and that’s a big deal for us but we feel pretty comfortable. We’ve got it well-controlled and going through the process.

So we’re learning a lot as we go through and pretty excited about the progress we are making.

David Schick - Stifel Nicolaus

Okay, thanks a lot.

Operator

Your next question comes from Daniel Binder with Jefferies.

Daniel Binder - Jefferies & Co.

Just two questions -- follow-ups to prior questions. First on the deflation issue, I understand the dynamic of following others on price and being able to pick up a little extra margin along the way as products deflate. I’m just curious if you can quantify to some extent what that looked like this quarter and it sounds like you are factoring that into your back half guidance as well. I am just curious if you see more rapid reaction to price from competitors -- does that bring the back half earnings into -- does that put it at greater risk if they start to react more quickly?

Laura Sen

You’re asking me to speculate on what the future will look like, which is pretty difficult. What I would say is that our -- you know, history is the best indicator of the future and we have seen a rational competitive set this year. We watch pricing very closely and I don’t foresee, at least based on what we have seen so far, that competition will behave very, very differently. I mean, actually going into this year, I thought that the competitive environment would be a lot more severe as people were trying to gain sales based on the weakened environment but that has not been the case. And overall, I mean, we’re more competitive so maybe we just feel it less, it’s hard to say. But right now, I think that our plans are reasonable.

Daniel Binder - Jefferies & Co.

Okay. Can you quantify at all in the quarter how much deflation margin pick-up may have contributed to gross margin?

Frank Forward

Good question, Dan but very difficult to quantify. I mean directionally, I am very comfortable in saying that we have been getting some pick-ups but it’s just difficult to quantify.

Laura Sen

Right, and I would also not ignore the fact that there were other contributing factors to the margin growth, which were partially in fuel costs and the costs to deliver the goods, partly in our improvements in salvage, shrink, and the perishable areas. So there’s not just deflation as margin improvement.

Frank Forward

We see big increases in units in a lot of places when we see some of these price drops down. Sometimes we do, sometimes we don’t. Again, it’s just a very difficult number to quantify.

Daniel Binder - Jefferies & Co.

Right, okay. Well, it just seems like a fairly consistent theme on the calls I’ve been on, so -- I’m not trying to beat you up over it. I’m just trying to understand how much the impact was.

The other question I had was with regard to merchandising, what you have planned that’s new for fall and holiday this year versus last year that may generate a bit more excitement in the club, particularly on the general merchandise side.

Laura Sen

Well, I mean we have continued to have a lot of excitement and success in TV and computers and faster, better machines and netbooks and so on. And I think that that will continue. I think our members have been really enthusiastic about what we are seeing and we have gained a fair amount of share, I would say, this year in those areas.

I mean, as far as the rest of the general merchandise departments go, I think that the overall marketplace is offering a more -- I guess breadth and availability, not necessarily new brands but better stuff, so to speak, in the branded areas, and I think that that’s working to our advantage.

We do see some categories turning around but overall I have to say the consumer is still very robust when it comes to food and consumables and very cautious when it comes to everything else.

Daniel Binder - Jefferies & Co.

Okay, thanks.

Operator

Your next question comes from Neil Currie with UBS.

Neil Currie - UBS

Good morning and thank you for taking my question. I just really wanted to ask about MFI. You are obviously getting great traffic in the stores from existing members. You are getting them to buy more food and they are coming more frequently but you mentioned how difficult -- more difficult it is getting new signings and that they were down. I just wonder how you can explain the disparity between the success you are having with existing members and maybe -- but not as much success as attracting new members. And do you need to market more aggressively?

Frank Forward

Well, as far as marketing more aggressively, you’ve got to remember -- I mean, this is a low cost business model and we only have so many basis points for doing market. But with that said -- as I said before, I think a piece of this is the economy. Getting people to come in and try us -- I mean, we are a membership business. It does cost $45 due to join and you’ve got to get people over that barrier.

Again, we do a pretty good job, if we can get them in, particularly with our direct mail pieces and the membership acquisition programs that we run twice a year.

I wouldn’t make as big a deal out of this -- I mean, last year we certainly did have some pretty good experience where we -- new memberships were slightly better than last year. There was only about 1% and historically, we typically do run a little bit below last year, particularly as we open up more and more new clubs and you cannibalize in the pool of new members to come in, if you will, as you open up a lot more new clubs as you cannibalize sales.

So again, we are very pleased with how the membership turns are going this year, with those renewal rates.

Laura Sen

The renewal rate means there are less members dropping off, so to a certain degree, it’s kind of like a see-saw, right?

Frank Forward

But again, last year we had an increase in renewal rates and this year is another year of renewal rate increases and with the economy that’s out there, we think that’s a pretty good result.

Neil Currie - UBS

Okay, thanks for that. Just the other question I was going to ask was on inventories, seeing that the inventories per club was up about 4% to 5%. Was that a little higher than you were expecting?

Frank Forward

Yeah, it was a little bit higher but again, as I mentioned in the call, it was like 3.8%. We have soft sales in those last couple of weeks of July and as we mentioned, sales -- particularly as the weather seemed to get a little bit better in the beginning of August, the sales seemed to come back and last week we were down to much better increase, what would seem more consistent with the rest of this year.

Neil Currie - UBS

Thanks, and just a final quick one -- I might have missed it but could you tell us what the current status is of the SKU count and have there been any material changes in the last quarter?

Laura Sen

We’re hovering around 7,200, 7,000 -- it’s not changed a great deal. We’re not looking to take it down. We’re looking to keep that same amount of selection for our members every day, so --

Neil Currie - UBS

As you go into the fourth quarter, will there be maybe less emphasis on general merch convert to last year and maybe slightly a bigger emphasis on food, or will the mix be similar?

Laura Sen

Not a great deal -- there’s a small number of clubs where because we are capacity constrained in the perishable refrigerated frozen areas, the building, we’ve cannibalized a little bit of general merchandise space but that is not an overall direction. We intend to keep all that interesting part of the business. It will come back. Right now it’s not the strongest growth area but it’s still an important part of what we do.

Neil Currie - UBS

Thanks very much.

Laura Sen

You’re welcome.

Operator

Your next question comes from the line of Robert Ohmes with Banc of America.

Robert Ohmes - Banc of America

Thanks. Good morning, everybody. Hey, actually just really one question on stores -- Laura, can you just remind us the strategy on that new prototype, you know the 85,000 square foot store that I think you are opening in Pennsylvania? And then maybe tie into that with the strength of the new stores, can you remind us how many stores you are targeting for next year and what would -- what has to happen to cause you to take that up or down? Thanks.

Laura Sen

The 85,000 square foot prototype will be deployed in a couple of different ways. First for less dense geography, it will be a format that we think will serve that middle-sized market a little bit better and offer [inaudible] in a larger club but just more efficiently. But I think as important or more important, it gives us the flexibility to go into some locations that we couldn’t otherwise go in with our full-size box. Certainly we have the flexibility to run clubs like this and we know that they can produce some very attractive ROIs, so we are going to be able to slip into some marketplaces that we know competition could not go and within our current geography.

So a little bit smaller, for smaller mid-sized markets, also for dense markets where we can’t get the full-sized box. And we’ve had an experience, I’ll just relate on the Cape in Hyannis where due to local restrictions, we could only put a 70,000 foot box roughly, and we’ve seen some very attractive volumes and returns out of that small little place, so we know we can do it operationally, merchandising wise. We’ve got a pretty strong logistics capability that produces some really nice volumes out of that little tiny box on the Cape. So having seen that, we feel confident that at 85,000, we can do a lot.

Going into the new club discussion, next year we hope to meet or exceed this year’s number of clubs. I would say that right now, we are feeling that if more opportunities come up that work for us, we would certainly take advantage of that but we are being very I think conscientious and diligent about what we take and where we take it to make sure that our future growth looks very robust.

Robert Ohmes - Banc of America

Great. Thank you very much.

Operator

Your next question comes from Mark Wiltamuth with Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

Good morning. I wanted to dig in a little bit on the negative 2% and the non-food comps. If you look across all those categories, are there any areas that look encouraging, or maybe some early signs of recovery?

Laura Sen

I would tell you that although there -- some departments have improved, other departments have perhaps gotten a little worse, so there’s not an overall improvement in trend in the whole business so I’ve seen as we go into back to school, we’ve seen some strength in some areas of home, housewares, residential furniture, domestics has turned but we’ve seen some other areas soften a little bit more. So this year, as an example, is UPS, a category that is dramatically lower in retail, lower in volume -- it’s just not happening as it was in the past, so you know, these things go up and down but I can't tell you that we are seeing a trend change overall in general merchandise.

Mark Wiltamuth - Morgan Stanley

Okay, and then switching over to the deflation topic, if you looked at the year-agos, when you were seeing the inflation in food, when do you think you are going to be at the worst of deflation and when do you think we will completely lap out of deflation?

Laura Sen

It will begin to flip in the third quarter. That’s when obviously fuel prices came down, commodity prices came down, and cost of goods started to come down, so there’s going to be some sort of point of crossover mid to late third quarter, I would say.

Frank Forward

And into the fourth quarter, so somewhere around end of third quarter, beginning of fourth quarter -- best as we can tell.

Mark Wiltamuth - Morgan Stanley

Okay and if you maybe just comment a little bit on what some of the grocers are doing in your trade area on price because there’s been a lot of discussion on the last several grocer conference calls of a significant price reductions and just -- what is going on in your trade area?

Laura Sen

We are aware of what they are doing but they are still on a high low model which requires their margins to be much higher to support what they do. And they are still unionized, they still use third party distribution -- there’s just thousands and thousands of SKUs that they run, so it’s -- it’s a different business model and from everything that we have looked at and we have looked at the statistics on a regular basis, they are gaining share from each other or other places but not from us. We are continuing to gain share again grocery.

Mark Wiltamuth - Morgan Stanley

Okay. Thank you very much.

Laura Sen

You’re welcome.

Operator

Laura Champine with Cowen has a question.

Laura Champine - Cowen & Company

Good morning. On the expectation for food deflation to subside a little bit in the back half of the year, what kind of visibility do you really have into that? Is that just an assumption that prices stabilize here or -- how long are your lead times into those categories for firm pricing?

Laura Sen

Well, obviously we are talking to the vendors everyday but what we know is what happened last year, so we have complete visibility on to history and how where we are today compares with that -- so I mean, we have pretty good visibility as to when those lines will cross over. But our information comes from the vendors.

Laura Champine - Cowen & Company

Okay, so are you assuming prices stabilize here or is there a -- do you really see less deflation coming -- going forward?

Laura Sen

Well, yes, stabilizing with that will in fact mean less deflation as the prices declined last year.

Laura Champine - Cowen & Company

Thank you.

Laura Sen

Does that make sense?

Laura Champine - Cowen & Company

It makes sense. Thank you.

Operator

Your next question is from Peter Benedict with Robert W. Baird.

Peter Benedict - Robert W. Baird

Thanks, guys. A couple of questions -- first, can you talk about the traffic and average ticket assumptions in the third quarter and fourth quarter merchandise comp plan?

Frank Forward

We are expecting for the traffic to continue very strong. The 4% comps in the third -- in the second quarter should be pretty [approximation] for the third quarter and then in the fourth quarter, probably also around that 4% and we are starting to get a little bit better on the average ticket in the fourth quarter as we cycle some of the deflation.

Peter Benedict - Robert W. Baird

Okay, and then on the inventory -- thanks for the color on that -- how should we be thinking about the year-over-year growth rate in inventory as we look to the end of the third quarter and fourth quarter, based on kind of how you are planning your inventory buys right now?

Frank Forward

Well, we have a sort of rule of thumb that we grow our inventories about half of whatever the comp sales increase is, so if we are planning a 5%, we would think the inventory would be 2.5 -- kind of how we would plan it, although generally we do a little bit better than that. We are planning for some slight increase, in the 2% range type of range for the back half.

Peter Benedict - Robert W. Baird

Okay, great. And then lastly just on the other revenue line, can you give us some color, Frank, as to what is going on there? You’ve had some growth rates jumping around and we’ve got acceleration in the back half -- what is driving that?

Frank Forward

Well, there’s a lot of different small pieces that go in there. Certainly one of the successes in the current year has been propane. That’s been a nice business for us. It indexes extremely well against the competition. Food court is in there -- it’s a bunch of different pieces that just sort of move around a lot, unfortunately.

Peter Benedict - Robert W. Baird

So why the acceleration in the back half? Was there something that happened last year that sets you up for acceleration?

Frank Forward

Most of that is food court and getting a little bit better and assuming the traffic keeps going through in the fourth quarter.

Peter Benedict - Robert W. Baird

Okay. Thank you.

Operator

Adrianne Shapira of Goldman Sachs has our next question.

Adrianne Shapira - Goldman Sachs

Thank you. My question really just focuses on the guidance going forward -- to date, it seems as if your guidance has been quite conservative as you have been handily beating that but now with these deflationary headwinds in the back half and as you lap those strong year-ago gas profitability numbers, it would seem that the guidance is a lot less conservative. One, is that do you think a fair characterization? And then two, if you still believe it’s conservative, where would you see the upside potential? Thank you.

Laura Sen

I think that it’s pretty clear -- the upside potential is for general merchandise to come back and the consumer to start spending on things that they are currently deciding not to buy and saving the money and so on. And we have very modest plans for general merchandise in the second half. That comes back. I see some very nice upside for us.

Frank Forward

Particularly in general merchandise -- we’ve got a business model that really is almost second-to-none in terms of being able to logistically handle chasing merchandise, should some strength in the general merchandise --

Laura Sen

Right, I mean, if we find a good buy in the marketplace three weeks before Christmas, we’ll take it.

Adrianne Shapira - Goldman Sachs

Okay, so just to be clear, the better August sales that you are seeing, it sounded as if it was partly due to improved -- more seasonal weather. As a result, are you seeing that general merchandise sales improve in August to date?

Laura Sen

The problem for that is that we have this mass tax holiday that we cycled this year that didn’t happen.

Frank Forward

And that was almost all general merchandise.

Laura Sen

Yeah, it was all general merchandise and it was big. So that’s a little mud in the water here.

Adrianne Shapira - Goldman Sachs

Okay, so the better sales are still more in the food consumables area, and perishables?

Frank Forward

Correct.

Adrianne Shapira - Goldman Sachs

Okay, best of luck. Thank you.

Operator

Next is Deborah Weinswig with Citigroup.

Nathan Rich - Citigroup

My first question was just regarding your seasonal business -- can you talk about what worked and what didn’t this summer, and any learnings that you can take in the fall and holiday this year?

Laura Sen

That’s a little difficult to apply because what we learn in the spring and summer really cannot help you with the fall too much because the buying cycles -- the lead times are longer than that but what I would say is that we saw -- I think that as we’ve mentioned before, some of our most expensive items in patio, swing sets, did better than lower ticket items, whether it was last year or in the category this year, so it’s always about the value. The members find the money for the great value items and the right items always sell.

That being said, the consumer is still sort of tenuous. We have to be inventive. You know, we have to be very inventive to find what they want and when we do, it’s always a success.

So I think that where other retailers have declared that they are going to lower their price points, that is not a direction for us.

Nathan Rich - Citigroup

Thanks, and then my next question is regarding the reward membership conversions. Are you doing anything in the club to drive those?

Laura Sen

Yes, absolutely -- we’ve made an effort to do some more in-club marketing to members who look like good target members, people with big baskets, and the MARM during the non-map period, member acquisition program period have focused on that and that’s been a really strong success for us.

Nathan Rich - Citigroup

Great. Thank you.

Laura Sen

I think that we can take one more question.

Operator

And we will take that final question, a follow-up question from Dan Binder with Jefferies.

Daniel Binder - Jefferies & Co.

Just to follow-up on the membership -- I think you said that the spring program met or exceeded your expectations. I was just curious what new things you did in the spring -- I think you were going to be trying some new approaches to attract members.

And then consistent with that question, what do you think the disconnect is on the spring program and the good conversions and the comments you made about new members and existing clubs being a bit softer?

Laura Sen

I think that as you’ll recall, it was two years ago that the MARMs came back, and so that was pretty much a new initiative last year, that they had sort of been around for a while and were getting some traction. This year I think they really owned what they did and they had this whole theme of having the conversation, which I really like, because it was probing around what the member likes about -- you know, do they like books, do they need diapers or whatever it is -- they are good cooks and they want fresh meat and have that conversation at desk. And that was the really successful initiative. I think that they owned it and they did a great job.

In terms of the new members, I think that Frank really said it well -- the economy has become a barrier to entry for people to buy a membership and that will speak to some of the softness.

Daniel Binder - Jefferies & Co.

Okay, great. Thanks.

Laura Sen

Okay, thank you very much for joining us today. I just want to wrap up by talking about our strategic focus. We’ve been working very hard this year to improve the overall shopping experience for our members. Our merchants have continued to find and offer better merchandise quality and value. Our operators have worked very hard to make the clubs more shop-able. Our logistics and replenishment people have been challenging themselves to be more efficient and I would say that the spirit of continuous improvement is pervasive in the company. I am very proud of what we have accomplished during the first half and I am very excited about what I see in terms of passion and commitment when I travel the clubs. We do expect the food and consumables will continue to be the primary drivers of our business and that discretionary spending will be under pressure. However, we have taken a very prudent approach to our guidance for the year and we know that if consumer confidence and spending recovers, we will be well-positioned for upside potential.

So thank you very much for joining us and talk to you soon.

Operator

And that does conclude our conference call. Thank you for your participation.

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Source: BJ's Wholesale Club F2Q09 (Qtr End 8/2/09) Earnings Call Transcript
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