Warehouse Club Membership Fees and the Long Case for BJ's Wholesale

Includes: BJ, COST, WMT
by: Neal Shanske

Rob Zenilman has a recent post on SeekingAlpha on warehouse club membership fees. Though the post is titled “Are Warehouse Stores Too Dependant On Membership Fee Income?” this post merely shows that this is the case, but doesn’t suggest any conclusion. I would maintain that not only is this desirable, it is an integral part of the business model.

There are 3 major players in the warehouse club market, BJ’S Wholesale (NYSE:BJ), Costco (NASDAQ:COST) and Sam’s Club, which is owned by Wal-Mart (NYSE:WMT). These businesses offer a wide range of product categories but typically limit brand and size selection for any given product. Costco, for example, sells only 2 brands of diapers, 1 of which is their house brand and in only 1 size package. Compare this to a local supermarket which will offer 4-5 national brands, different styles within brand, and several package sizes per brand as well. BJ’s carries more SKUs than Costco, but still far fewer than traditional stores.

Limiting product selection gives warehouse clubs additional leverage with suppliers as there is great value in being the only choice. Warehouse Clubs pass this value on to consumers; Costco is famous for never marking up prices more than 14%.

Rob noted:

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%

So, the bulk of operating income is not from selling merchandise, but from selling memberships. Bad news, right?

Wrong. There’s no great secret being uncovered here, this is the warehouse club business model.

Reasons why dependence on membership fees is good:

1) Float
Members pay $45 at BJs or $50 at Costco per year. They pay this up front at the beginning of their membership year, and though it gets recognized over the next 4 quarters, the Comapny has all the cash up front. This is an attractive source of low cost working capital. Money can be used to develop inventory, open new clubs, market memberships or can just be allowed to accrue interest. One result of this may be that unlike many retailers, both BJ and COST have little long term debt, and none net of cash.

2) Ability to “underprice” competitors
Since over 70% of profit comes from membership fees, warehouse clubs have the ability to price items at lower margins and still make money. The typical customer will compare the price on their receipt to other stores. They won’t first allocate a percentage of their membership fee. This creates a perception for customers that warehouse club prices are lower than their actual cost to the consumer.

3) Repeat Customers
Customers who have paid a membership fee are likely to shop more frequently and conduct more of their purchasing at the club in order to take full advantage of their membership fee. Since they have already paid in, there is a “switching cost” during the membership term.

4) Elasticity in Membership Fee
Costco recently raised it’s membership fee by $5 to $50 and BJs may well follow. BJs raised rates from $40 to $45 several years ago and renewal rates remain above 80%. In addition both clubs have had success in offering their premium membership levels($80 forBJs, $100 for Costco).

Both stocks are well off recent highs, but BJ looks to me like the much better buy. BJ trades at only 13.5 times next year’s earnings, has a strong balance sheet with only $10MM in long-term debt, and owns substantial real estate assets to support it’s value. In addition, as Rob points out, there have been persistent rumors that it might be a takeover target.

Unlike Costco, BJs does not have a national footprint, and some have expressed concern about its ability to compete. However it continues to do well in markets where it is competing with Costco, continues to expand, and has differentiated itself somewhat. BJs has focused on the consumer as opposed to the small business, and as a result, stocks a larger number of SKUs and somewhat smaller package sizes.

Recent drops in gasoline prices are likely to lower revenues and earnings as BJS operates gas stations at many of its clubs, so there may soon be an opportunity to buy lower. Even at $26 though, I think this is good for the long term.

Disclosure: I own shares of BJ