Are Warehouse Stores Too Dependant On Membership Fee Income?

Rob Zenilman submits: When analyzing discount retail stores, I was surprised to find out how dependant warehouse stores were on membership fee income. As a sector (on Yahoo), discount & variety stores are sporting a TTM P/E of 20.0. Costco's (COST) P/E is almost dead-on with the sector at 20.7, and BJ's Wholesale Club (BJ) trails at 14.78. Both Costco and BJ's require customers to purchase annual membership fees between $45-$100. For the 12 months ending with 2006's second quarter, these fees accounted for 72.7% and 83.9% of operating income for Costco and BJ's, respectively.

The following chart summarizes trailing 12 month & forward P/E ratios for key discount retail stores:

Both Costco & BJ's have kept membership fees as a percentage of total revenue remarkably flat (and similar to each other) over the past 2 years:

As I alluded to before, the ratio of membership to operating income is significant:

As you can see, BJs relied entirely on membership fee income for operating profits in 2004-Q4, 2005-Q2 and 2006-Q2.

For the 12 months ending with 2006's second quarter, Costco's membership fee revenue was 72.7% of operating income and BJs was 83.9%. BJs has already reported Q3 numbers - the TTM ratio went up 4.5% to 88.4%

Both warehouse stores offer two levels of membership, lets call them standard and premium. Customers with premium membership get 2% back on their purchases. For standard membership, BJs charges $45, and Costco charges $50. For premium, its $80 and $100, respectively.

This past May, Costco raised their standard membership from $45 to $50. This is expected to add $75mm in annual revenue. If we add this to the last TTM membership fee revenue, Costco's ratio of membership fee revenue to operating income increases from 72.7% to 77.5%.

All thing being equal, this opens the door for BJs to boost its operating income by raising its annual membership fees, currently $5 and $15 cheaper than Costco's (for standard and premium, respectively).

Comment: With BJs recent weakness, there is speculation how it will fit into Eddie Lampert's Sears Holdings (SHLD). Costco recently warned on earnings, but that might just be a temporary blip.

See: Costco's Q2 earnings conference call transcript.

Comments

[Travis Johnson:]

Robert,

This is undoubtedly true -- but does it mean anything? After all, the margins of 2% or so are pretty typical of grocery stores, whether that margin comes from a fee the customers have to pay or a slightly higher price. Increasing sales without increasing the customer count is the only way to become less dependent on the membership fee, and in many cases that means relying on customers to buy bigger ticket items like jewelry and electronics and furniture ... which, as you can see from your BJs chart, generally happens more often in the fourth quarter with holiday shopping. That was also the problem with Costco's results this past quarter, with lower than expected TV and furniture sales. Expanding gross margins overall would be bad for business, in that it would get rid of the value proposition, so they need to keep opening new stores, bringing in new members, and hoping for some incremental increases in sales to give a little boost to profit margins. I do find it interesting that the profit these stores make is roughly in line with their membership income -- but sales and membership fees can't really be separate in the scheme of these business plans. The stores are designed to make the payment of that membership fee seem attractive, as high renewal rates show, and overall margins for these companies are generally in line with the large discount retailers and grocery stores that are their competition.

I haven't found Costco cheap enough to buy yet, but I remain tempted ... I'm hoping for a couple more bad quarters to drive the price down.

Cheers,
Travis

2006 Sep 08 11:57 AM

[downward sp...:]

A couple more bad quarters? The Q1 estimates will be blown away.

2006 Sep 16 06:46 PM

[Inelegant I...:]

Travis is right, I'm not clear why it should be a problem that the bulk of income comes from membership fees. From the very start of the warehouse club industry that was the business model, and the continued growth of these companies is proof of its efficacy. I've posted a more detailed response at Inelegant Investor

2006 Sep 09 09:12 PM

[Skagen:]

The obvious – and missing – conclusion is that the membership fee is not standalone revenue. Its merely an up front payment on your your annual shopping commitment when you join and it in fact induces customers to shop more and take advantage of their sunk costs. Which is why these things are called “Wholesale....Clubs”.

You might something if you pointed out that retail margins are pretty low if $50 per customer can make up 75% of annual profit. But breaking out the annual membership “fee” as supposedly independent revenue is a pointless exercise.

You could also view the 75% as an indicator that these companies have customers who are extremely commmited.

2006 Sep 11 11:24 AM