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

Q3 2007 Earnings Call

November 20, 2007 8:30 am ET

Executives

Herb Zarkin - Chairman, President and CEO

Frank Forward - CFO

Cathy Maloney - VP, IR

Analysts

Deborah Weinswig - Citi

Chuck Cerankosky - FTN Midwest Securities

Daniel Binder - Jefferies

Charles Grom – JP Morgan

Robert Drbul - Lehman Brothers

Christine Augustine - Bear Stearns

Peter Benedict - Wachovia

Chuck Ruff - Insight Investments

Gregory Melich - Morgan Stanley

Thomas Forte - Telsey Advisory Group

Operator

Good day everyone, and welcome to the BJ's Wholesale Club Incorporated third 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. t this time, I would like to turn the call over to Ms. Cathy Maloney, Vice President of Investor Relations. Please go ahead.

Cathy Maloney

Thank you. Welcome everyone to the BJ's Wholesale Club third quarter earnings conference call. With me this morning are Herb Zarkin, Chairman, President, and Chief Executive Officer; and Frank Forward, Chief Financial Officer.

Before we begin, let me remind you that the information presented and discussed today includes forward-looking statements which are made under the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from these forward-looking statements.

The risks and uncertainties related to such statements are detailed in our fiscal 2006 10-K and subsequent 10-Qs for fiscal 2007. While the company may elect to update these forward-looking statements, the company specifically disclaims any obligation to do so, even if the company's estimates change.

Now I'll turn the call over to Frank Forward.

Frank Forward

Good morning, everyone. Thank you for joining us this morning. For the third quarter ended November 3, 2007 net income was $22.7 million, up $0.35 per diluted share. Comparatively for the third quarter of 2006, net income was $18.3 million, or $0.28 per diluted share.

Results for the third quarter of 2006 included a loss of $1.4 million post-tax, or $0.02 per diluted share related to the discontinued operations of the ProFoods restaurant supply clubs. Thus, the third quarter net income on an adjusted non-GAAP basis was $0.35 per diluted share this year, versus $0.30 per diluted share last year, an increase of 16.7%.

Net income for the first nine months of 2007 was $72.6 million, or $1.11 per diluted share. These results included:

·        Income of $3.6 million post-tax, or $0.05 per diluted share, from favorable state income tax audit settlements in the second quarter;

·        Income of $2.4 million post-tax, or $0.04 per diluted share, from the favorable disposition of a ProFoods Club lease in the second quarter;

·        Income of $0.6 million post-tax or $0.01 per diluted share from the sale of pharmacy assets in the first quarter.

Net income for the first nine months of 2006 was $60.2 million, or $0.90 per diluted share. Last year's results included income of $2.1 million post-tax or $0.03 per diluted share, for House2Home bankruptcy recoveries; and a loss of $4.1 million post-tax, or $0.06 per diluted share, related to the discontinued operations of ProFoods.

Adjusting for the unusual items in both years, year-to-date net income on an adjusted non-GAAP basis was $1.01 per diluted share this year versus $0.93 per diluted share last year, an increase of 8.6%.

Moving to sales, net sales for the third quarter of 2007 increased 8.0% to $2.1 billion. Comparable club sales for the quarter increased by 3.4%, including a negative impact from sales of gasoline of approximately 0.2% and a negative impact from the absence of pharmacy sales of approximately 0.4%. Thus, comp merchandise sales, which exclude gas and pharmacy, increased by 4.0%.

Next I'll break out comp sales by major market, including the impact from sales of gasoline. I'll begin with the regions, then read four columns beginning with the third quarter comps, then third quarter gas impact, year-to-date costs, then year-to-date gasoline impact.

Region

3Q Comp

3Q Gas Impact

YTD Costs

YTD Gas Impact

New England

2.6%

-10 bp

2.2%

60 bp

Upstate New York

2.6%

-200 bp

3.5%

10 bp

Metro New York

6.7%

-30 bp

5.5%

No impact

Mid-Atlantic

4.8%

110 bp

4.7%

150 bp

Southeast

-1.1%

-10 bp

[-40 bp]

140 bp

Total Chain

3.4%

-20 bp

3.1%

70 bp

For the third quarter, we estimate that the negative impact on comparable club sales from new competition and self cannibalization was approximately 1.5%, which is about the same level as last quarter. Excluding sales of gasoline, traffic decreased by approximately 1% during the quarter, and the average transaction amount increased by about 5%. For the third quarter, comp sales of foods increased by about 6%, and general merchandise sales increased by about 2%.

Strong categories versus last year included televisions, office supplies, small appliances, cheese, coffee, dairy, frozen, juices, meat, milk, office supplies, produce, soda and water. Weaker categories versus last year included apparel, automotive and tools, cigarettes, pre-recorded video, residential furniture and tires.

Now let me go through some of the third quarter income statement detail. Compared to the third quarter of last year, membership fee income and other increased by about 7.4% in dollars. Cost of sales, including buying and occupancy, increased by 34 basis points. SG&A expense decreased by 41 basis points and preopening expense was approximately $0.9 million versus $3.1 million in last year's third quarter.

The 7.4% increase in MFI and other revenue was driven by the $5 membership fee increase that went into effect on January 1, 2006. We are now close to cycling through the impact of this increase.

At quarter end, membership renewal rates were tracking flat to last year's levels of 87% for Business members, just slightly below last year's level of 83% for Inner Circle members. The slight drop for Inner Circle Club members is due to, we believe, the impact of last year’s $5 fee increase.

The increase of 34 basis points in cost of sales as a percent of sales mostly reflected the impact of gasoline margins on cost of sales, which was an unfavorable 32 basis points. The rise in gasoline prices had a significant negative effect on our gas margins in the third quarter. This was partly offset by improved merchandise margins which was 3 basis points higher than last year. The improvement was driven by strong growth in sales of high margin perishables, particularly produce and meat. However, this was mostly offset by the impact of competitive price reductions taken earlier this year and some unfavorable sales mix issues. The predominant unfavorable mix issues were strong sales in below average margin departments such as televisions, and weaker sales in some above average margin departments such as apparel and jewelry.

The decrease of 41 basis points in SG&A expense reflected in a number of factors. Other than good expense leveraging from the strong sales gains, some of the larger factors were:

·        A decrease in home office payroll dollars versus last year and better leveraging Club payroll; totaling together, worth about 14 basis points.

·        A decrease in marketing expense of about 14 basis points; and

·        Savings and pharmacy expense worth about 14 basis points.

I should also mention that these factors were partly offset by an increase in bonus accruals of about 16 basis points due to last year's unusually low level of bonus accruals.

Pre-opening expense was approximately $0.9 million versus $3.1 million last year, which reflected a low number of club openings versus last year. Interest income was $1.0 million this year versus $0.5 million last year, which mostly reflected higher levels of invested cash as compared to last year.

Our tax rate for the third quarter was 40.5% versus last year's unusually low rate of 37%. Last year's tax rate benefited from state income tax credits related to the relocation of our Massachusetts cross dock facility.

Moving to the balance sheet, inventories were in good shape at the end of the quarter. The average inventory per club at the end of the quarter decreased by approximately 2% versus last year. This decrease was primarily due to the benefits of our SKU reduction and inventory rationalization efforts this year.

Our accounts payable to inventory ratio at the end of the quarter was approximately 69%, compared to approximately 64% at the end of last year's third quarter. This was also due to our SKU reduction efforts this year, as lower inventory levels drive improved inventory turns, which leads to increases in accounts payable to inventory ratio.

We ended the quarter with approximately $117 million in cash compared to $40 million in cash at the end of last year's third quarter. We had no short-term debt at the end of quarter versus $35 million at the end last year's third quarter.

During the third quarter, the company purchased approximately 1.5 million shares of BJ's common stock at an average cost of $33.76 per share for a total expenditure of $50.7 million. Year-to-date, BJ's has repurchased approximately 3.2 million shares of common stock at an average cost of $34.44 for a total expenditure of $110.3 million. At the end of the quarter, we had approximately $43 million remaining for buybacks under then-existing authorization.

As announced in our press release this morning, BJ’s board of directors has approved an increased share repurchase authorization of an additional $250 million. This additional authorization was approved because of the improved cash flow as a result of our inventory reduction efforts and our lowered expectations for capital spending this year. Our intent is to continue with our current practice of steadily spending against the authorizations, as market conditions warrant.

Now I’ll turn the call over to Herb for a review of BJ’s accomplishments during the third quarter.

Herb Zarkin

Thanks, Frank and good morning, everyone. As we have discussed since my return to the CEO chair at BJ’s, our strategy is to build long-term relationships with our members by having the right prices on the right merchandise and to present our merchandise in attractive, shoppable presentations.

In the third quarter, we continued to improve our offerings in all of these areas. Our positive sales results for the quarter were driven primarily by continued strength in perishable foods, as well as stronger sales versus last year's through our fall members acquisition program.

For the quarter, comparable club sales of our high margin perishable foods increased by approximately 8.3%, up from 7.8% in Q2 and 3.2% in Q1. As we have said in previous calls, perishable foods represents our greatest opportunity to capture market share from supermarkets because of the outstanding savings we are able to provide on a wide assortment of items. Our team members are doing a tremendous job of raising our standards of quality and presentations in this area, particularly in the produce and prepared foods, and we are pleased with our members’ response.

Our fall members acquisition program, which began in late September and will run through December, got off to a strong start, generating more trial members and more program-related sales during the third quarter compared to last year. Some of the credit for these results certainly goes to our members acquisition and retention managers, or MARMs, who applied their experience from the spring members acquisition program to the fall program, and have continued to build a culture within the clubs, focused on membership.

Another factor that had a positive impact on our comp sales during the quarter was keeping our prices at competitive levels. We have been able to improve our price positioning by putting more resources against this effort, both at the home office and in the clubs, by refining the method by which we make competitive price checks and by responding more quickly to market conditions. As compared to last year, while we reduced the number of coupons distributed, we made more effective use of those that we did distribute.

Let me talk about some other things that we're doing to ensure that our members enjoy their BJ shopping experience. To make our clubs easier to shop, we've made a number of improvements in our merchandise presentation. For example, during the third quarter we tested a new waterfall display of large, high-definition televisions that quickly became the prototype for all clubs. We also installed a new Sony flat-panel television display, showcasing Blu-ray technology as well as an attention-grabbing Nintendo Wii end cap.

In the apparel area, we edited assortments and trimmed inventory, and at the back of the club we continue to upgrade presentations of perishable food by replacing coffin-style refrigeration cases with multi-deck cases.

Another way that we improved the value of membership during the third quarter was through the introduction of the BJ's Visa card. All BJ's purchases made with this new card become eligible for merchandise rebates that are mailed with the members' monthly statements.

Looking out to the fourth quarter, I am very excited about our assortments for the holidays. The majority of our holiday merchandise was selected by the team of buyers that Laura Sen put into place last January. I believe they've done an outstanding job of meeting of their three objectives, which are: to deliver everyday value, merchandise excitement and efficient assortments.

I'd like to give you a few examples of each of these objectives. First is value. I spoke a moment ago about BJ's return to the more competitive, everyday low pricing. We continue to put resources against this important objective. We're continuing to demonstrate to our members the value of the BJ's membership.

Second, there are many ways to deliver merchandise excitement. This year's perishables are a major area of strategic focus for us. We are particularly proud of the new additions in our European cheeses, natural chicken, beef and pork, as well as many items in the organic produce including salads, carrots, tomatoes and spinach. We're also proud of our fine restaurant cuts of meat including rack of lamb, prime ribs and veal chops.

New prepared foods for this holiday season include imported fresh Italian ravioli, pork osso bucco, veal meatballs and prepared appetizers such as filet mignon wrapped in bacon.

Technology is another major focus this year. We have HDTVs from Sony, Sharp and Samsung, plus we offer value brands including Vizio and Olivia. As I mentioned, we are offering Blu-ray DVD players and movies and we are making a big statement in digital photo frames with a fine assortment of sizes and price ranges.

Our seasonal gift ideas come from a multitude of sources from around the world, as well as from the popular high-end gift catalogues. Key items in the gift appliance aisle this year include several types of HoMedics massagers, a 40 bottle dual temp Haier wine cooler, an electric fireplace, a keg refrigerator, and an old fashioned popcorn cart.

The third objective of the merchandise team is to offer efficient assortments. This year our trade department exemplifies what we mean by an efficient assortment: crisper, cleaner presentations and more branded TV toys.

Moving on to the holiday marketing, this year we're taking a break from our traditional holiday radio and TV campaigns to focus on members acquisition and retention. Our major direct mail promotion for the holiday includes our annual toy catalogues, our November BJ's Journal, which showcases holiday items and gourmet foods; and our entertainment gift guide -- a catalogue of gifts, giftware, games, electronics and specialty foods which we mailed in December.

With that update I'll turn the call back to Frank, who will review our guidance for the fourth quarter.

Frank Forward

Thanks, Herb. For the fourth quarter, which will include 13 weeks of sales this year versus 14 weeks of sales last year, we are planning for total sales to increase in the range of 0.5% to 2.0%. We estimate that the negative impact of last year's extra week of sales will be worth about 7% to total sales.

Comp sales increase of 4% to 6% which includes a favorable impact from gasoline sales of about 150 basis points to 250 basis points, and an unfavorable impact from the absence of pharmacy sales worth approximately 40 basis points.

Our fourth quarter merchandise comp sales, excluding the impact of gas and pharmacy, is planned in the range of 3% to 4%.

However, our Q4 sales guidance does not flow evenly across the months. We are planning for merchandise comp sales, excluding the impact of gas and pharmacy, to be around 4% for the months of November and December combined, and flat to up 2% for January. The lower January cost is primarily due to needing to cycle last January's high levels of merchandise markdowns, taken as a part of our corporate restructuring.

We expect membership fee income and other to increase 4.5% to 5% in dollars. As compared to previous quarters, the Q4 percent growth versus last year will moderate as we fully cycle the benefits of the $5 membership fee increase that went into effect in January of 2006.

We expect cost of sales as a percent of sales to increase 5 basis points to 15 basis points, an increase that is lower than in previous quarters this year. It does reflect an unfavorable impact of planned high gasoline prices and weaker gasoline margins, as well as unfavorable leveraging of buying and occupancy expense, due to the extra week of sales from last year's 53rd week.

However, it also reflects the benefits from a strong increase in merchandise margins, excluding gasoline, due primarily to the unusually high level of markdowns taken last year as a part of our restructuring; and a better mix of sales in the fourth quarter of this year, with stronger results expected from high margin departments such as perishables, apparels, jewelry and holiday seasonal items.

We expect SG&A expense as a percent of sales to decrease 100 basis points to 110 basis points, due to the following factors:

·        Last year's unusual charges of 86 basis points, which included 35 basis points for asset impairment charges;

·        31 basis points for pharmacy closing expense;

·        20 basis points for severance expense.

·        Expense savings from our home office staff reductions and pharmacy closings worth about 13 basis points.

·        Lower levels of advertising expense and better leveraging of club payroll versus last year are worth about 29 basis points.

Partly offsetting these favorable items in SG&A is a planned increased of about 30 basis points to 40 basis points in bonus accruals versus last year's unusually low level. We are planning for :

·        Preopening expense of $1.2 million, down from $3.8 million last year due to a lower number of new club openings.

·        A tax provision rate of 40% to 41% versus last year’s unusual low rate of 37.8%, which included the remaining portion of the state income tax credit related to the relocation of our cross dock.

·        Interest income of $1.1 million this year versus $0.1 million last year.

·        Finally, diluted EPS in the range of $0.70 to $0.74 per share as compared to last year's $0.18 per diluted share.

However, as a reminder, last year's fourth quarter included many unusual income and expense items resulting in a net expense of $0.40 per diluted share. The unusual items included:

·        Income of $0.06 from the 53rd week.

·        Expense of $0.02 from discontinued operations related to ProFoods.

·        Various other expenses totaling $0.44 per diluted share, including $0.23 in closing cost for ProFoods Restaurant Supply; $0.08 for asset impairment charges; $0.07 for pharmacy closing costs,;$0.04 for severance expense; and $0.02 to increase our credit card claim reserve.

Adjusting for these unusual items on a non-GAAP basis, last year's Q4 diluted EPS would have been $0.58 per share. On this basis and using the mid-point of this year's Q4 guidance of $0.72 per share, this represents an increase of 24% versus last year.

This strong growth in EPS is driven by expected strong comp sales and by the cycling of last year's unusually high level of merchandise markdowns, taken as a part of last year's restructuring.

Based on the factors I just outlined, our full year guidance is as follows:

·        A total sales increase of 5% to 7%, including an unfavorable impact of 2% from last year's extra week of sales.

·        Membership fee income and other to increase by 7% to 8% in dollars.

·        Cost of sales to increase by 27 to 31 basis points.

·        SG&A expense to decrease by 52 to 56 basis points.

·        Pre-opening expense of about $4.5 million to $5 million versus $9.5 million last year.

·        Interest income of about $3 million to $3.5 million versus $2.6 million last year.

·        An income tax rate of about 38.6%.

·        Capital expenditures in the range of $90 million to $100 million.

·        Net cash provided by operating activities of approximately $275 million to $300 million.

Finally, based on those assumptions, diluted earnings per share on a GAAP basis of $1.81 to $1.85 versus $1.08 per diluted share last year. This is $0.03 per share was higher than the midpoint of our previous guidance range due to the favorable third quarter results.

To aid in your understanding let me recap the unusual items that will affect this year's full year results.

Our guidance for fiscal 2007 reflects $0.10 per diluted share of income from the following unusual items:

·        Our ProFoods lease reserve adjustments at $0.04.

·        Favorable state income tax audit settlements worth about $0.05.

·        The sale of pharmacy assets during the first quarter worth about $0.01.

Last year's GAAP earnings of $1.08 per diluted share included expenses of $0.42 per diluted share from unusual items comprised of the following:

·        Expenses of $0.43 per share from the fourth quarter, as mentioned earlier.

·        Expense of $0.08 per share from the ProFoods loss in discontinued operations.

·        Income of $0.06 per share from the 53rd week.

·        Income of $0.03 per share from the House2Home reserve adjustments.

Adjusting for all of these unusual items in both years on a non-GAAP basis, the midpoint of our guidance would be $1.73 per share this year versus $1.50 per share last year, an increase of 15%.

Now, as we usually do at this time of year, we will provide some preliminary earnings guidance for 2008. For the full year, we are projecting comp sales to grow 4% to 6%, assuming no impact on comp sales from the sale of gasoline. This increase is partially driven by expected higher levels of inflation in the costs of some of our merchandise.

The balance sheet, we are planning for a CapEx budget of $120 million to $140 million. We expect to open four to five new clubs next year, all in our existing markets. We expect to be capital self-sufficient with cash flow from operating activities of about $250 million to $275 million and we expect to buyback about $150 million to $200 million of stock over the next 12 to 18 months.

With those assumptions, we are projecting EPS in the range of $1.85 to $1.95 per diluted share. The midpoint of this guidance is $1.90, which is a 10% increase versus $1.73, the midpoint of this year's guidance on a non-GAAP basis, excluding unusual items.

We will go into more detailed guidance during our fourth quarter conference call which is scheduled for Wednesday, March 5, 2008.

I will turn the call back over to Herb.

Herb Zarkin

Thanks, Frank. Before I turn it over to Q&A, let me say that we have every reason to be optimistic about our fourth quarter. Inventories are in great shape, we have exciting merchandise with tremendous values, and our team members are energized and enthusiastic.

While we recognize that concerns about the housing markets, rising oil prices may dampen discretionary spending, we believe that comp sales will continue to grow, particularly in perishables, consumer electronics and televisions, which have been strong all year.

Our forecast is for a merchandise comp increase of about 4% for November and December. But with that said, if there's an upside potential for fourth quarter earnings, the improvement would come from higher comp sales increases. If there is a rush of business, we are in a very good position to take advantage of it.

Now I will open the call to questions.

Question-and-Answer Session

Operator

Your first question comes from Deborah Weinswig - Citi.

Deborah Weinswig - Citi

Herb, I know that there's been a lot of work that's been done in terms of the SKU reduction/rationalization program. Can you talk about where you are there in terms of number of SKUs and what you hope to achieve by the end of the year?

Herb Zarkin

Well the number of SKUs that were down in any given quarter varies because of seasonality. We've been running down 700, 800 SKUs in the third quarter. In the fourth quarter we think we'll be in that same kind of range. Certainly at the end of the quarter we'll have less SKUs because a lot of the seasonal SKUs will disappear.

This is an ongoing battle; we are not done yet and we are not rushing to get it done. We are doing it in an intelligent way. We review every time we make these judgments. We see what the results are, we see if the other SKUs that remain pick up the slack, what happens with it.

So it's an ongoing process. –We are not going to be done with SKU rationalization, let me put it that way. We think there's another pickup next year of some number -- it might be 100, it might be 200 SKUs, there's no magic number to it at this point in time.

Deborah Weinswig - Citi

I believe that not all of the clubs had MARMs as of the end of last quarter. I don't know if you've been able to close that gap by the end of this quarter, but can you talk about any differences in terms of membership acquisition in those clubs that did have the MARMs versus those that didn't?

Herb Zarkin

We've been running about 160 MARMs right now for this quarter, which is about as high as we ever thought we were going to truly get and we are pleased with that. We don't quantify the differential by location with MARM or without MARM. We're going to do a thorough review of all the activities the MARMs have done this year during the spring of this coming year when we get a chance to see everything as it flows through.

We may or may not at that time give you some more information as to  what the MARMs produced or didn't produce. Most of it is very confidential, we certainly don't want it to be displayed publicly as to whether their performance has really helped us or not helped us, so we are reluctant to give you too much information.

Deborah Weinswig - Citi

Frank, I believe that CapEx guidance as of the end of last quarter had been $110 million to $120 million for this year and now it's $90 million to $100 million. Can you talk about the differential between the guidance in the two quarters?

Frank Forward

We are still holding in reserve some money for some clubs next year and then just generally some spending almost in all areas has just been a little bit less than what we had expected. We are trying to give you the best number we know right now.

Deborah Weinswig - Citi

But no changes in remodel activity?

Frank Forward

No. We will give you an update at the next quarter call as to what we are planning for next year. We are going through those plans right now.

Operator

Your next question comes from Chuck Cerankosky - FTN Midwest Securities.

Chuck Cerankosky - FTN Midwest Securities

Frank, in looking at the working capital, it was a great performance there. You mentioned some of it was due to SKU reduction and yet the sales seem to be picking up. Are you comfortable that inventories are not too tight going into the quarter?

Herb Zarkin

We are very comfortable with our inventory position. A lot of it does come from SKU reduction, there is no doubt about it. But a lot of it comes from the flow of inventory. How we purchased the inventory, how we flowed it into country if it is an overseas purchase, or even manufactured here in the United States or distributed through United States. We have gotten much more sophisticated as of late of how to think about just in time inventories and it's made the clubs a lot easier to present the goods and show the merchandise really well. The clubs have done a great job in how they present the goods today.

We are not the least bit concerned about the reducing of the inventory levels. It just makes it good for everybody in our organization, and it is very good for the membership because the customer can come in and she can clearly identify the products much more so this year than she would have done last year when she was shopping. It’s a good thing, but the level of inventory has no bearing whatsoever on our ability to do some big sales.

Chuck Cerankosky - FTN Midwest Securities

Do these flow improvements include both food and general merchandise categories?

Herb Zarkin

Absolutely, yes. There is more opportunity in general merchandise, especially on importing for the next year or two because we are learning more about that as we go. But most of our food products or almost 90% of the food products we carry are replenish on a regular basis. It's just a question of the skill sets of how we bring the merchandise in.

Also, we did a lot less promotions this year which helped us roll in the inventories and make it cleaner and crisper for the clubs to be able to take care of the merchandising. In the past if we ran a big promotion and it didn't sell out well, what did we do with the merchandise? We didn't have a home for it, it wasn't a natural item.

Today, we are promoting – when we do promote, which is not that often -- we do promote natural items that have a home going forward so if it's a success, we buy more; and if it wasn't a success, we don't reorder next week and we are right back on the inventory level.

Chuck Cerankosky - FTN Midwest Securities

Tires disappointed again, Herb. Any thoughts on that category?

Herb Zarkin

I am disappointed in our performance in tires. I think most of the performance is very directed inward, I'm not going to blame the outside world for tires or anything else. I think we haven't put the resources that are required to really do the tire business the way it should be done.

This was the decision I made at the beginning of the year. I don't have money for guns and butter, I don't have enough people that can do all of this multi-tasking, 700 different attempts to get everything done.

Tires is one of the decisions I've made. I was just going to watch it and see what happened this year. We are meeting on a regular basis on the tire business to try to find better ways to promote the tire business and to run the tire business. We're not happy with its performance at the present time; but as I say, again, I think most of it's internal.

Chuck Cerankosky - FTN Midwest Securities

Are there any thoughts about using that space for other categories?

Herb Zarkin

We always look at the size of the clubs as to whether we are undersized in the back of the club, if we put the tires in the tire bay to sell them there or we build an appendage to sell the tires. These are things that we do on a regular basis. But by and large, with the exception of one or two huge clubs -- Queens, New York for example is one -- where we needed the tire bay space, we needed where the tires were in the back of the club, we needed that space. Today we don't have any real plans one way or the other what we're going to do; it's in the process of being formulated and we'll share that with you come next spring when we finally decide what we are going do with it.

Chuck Cerankosky - FTN Midwest Securities

On the Membership Acquisition Program, any read so far on what kind of retention you're getting from these people who are signing up? How likely are they to become permanent members?

Herb Zarkin

All we are going to say is we are very pleased with the results of the Members Acquisition Program at this time. As I say, it's not an easy thing to measure because it rolls over and it rolls over. Some members renew right away, some members renew in three months. So we have to have a period of time to be able to shake all this down.

As I say, probably next spring we'll make some comments about it but at this point in time they are not going to be very specific, but there will be some general comments. Other than to say we are very pleased with what the Members Acquisition Program has produced, and we're very pleased with what the MARMs are doing, and we're very pleased with what the whole clubs are doing now, because management of clubs are very much involved in this. They understand how important this is for the membership, and for the success of the company. Generally, it has really helped make the culture that much better in the clubs.

Operator

Your next question comes from Daniel Binder - Jefferies.

Daniel Binder - Jefferies

The couponing that you talked about that occurred last year, a lot of which has not been repeated this year, can you give us a little bit of a sense of what kind of margin benefit that may have provided? Perhaps what kind of sales detriment it may have been? Also, what should we expect over the next couple of months with regard to couponing versus last year?

Herb Zarkin

The only thing we're prepared to say is that we ran substantially less coupons this year than last year and that the coupons that we did run this year produced a wonderful result and we're pleased with that. But we don't want to get into the margin impact of couponing. The only part we will get into is that when you have couponing on a global basis it does tend to build inventories, slows down your turn and makes it more difficult for the clubs to function; makes it more difficult for the consumer to find the inventory in the club, and that's really where the big benefits come to us.

Everything else is just part of making up of the meal, if you would. Those are the key things that we wanted to get out of it, and so that's about all we're going to talk about at this point in time.

Operator

Your next question comes from Charles Grom – JP Morgan.

Charles Grom – JP Morgan

Frank, a question on your gross profit margin guidance for fourth quarter, 5 basis points to 15 basis points of expansion. Provided that the fourth quarter last year compressed, I believe, a 110 basis points to about 8.9%, the guidance seems pretty conservative to me.

I'm wondering if you could discuss some of the assumptions embedded in your outlook?

Frank Forward

I'm not sure if I would classify it as conservative. It's our best guess of what we think the quarter's going to be. It certainly was built in there as continued strength within the perishable business, which have a higher margin. We are expecting some comeback in strengths in the apparel and jewelry margins, which would help some, so we'll have to see how that works out.

Generally, obviously the absence of the fairly heavy round of markdowns that we took in the fourth quarter last year, put that all together and that's what our modeling is coming up with.

Charles Grom – JP Morgan

Just to your apparel point, I know October is a little bit soft, we've heard almost universally that November is improving. I'm wondering if you could give us a little sense for how things are breaking here, month-to-date?

Herb Zarkin

When we see cold weather, we see cold weather goods fly out of the building. Cold weather for one day -- you need cold weather for two, three, four days. When we saw the cold weather hit, it was very rewarding, we felt very good and we saw good sales across all cold weather products.

Charles Grom – JP Morgan

Herb for you, on the MARMs, beyond what that program is going to do for acquiring and retaining new members, I'm wondering what the benefits are from the MARMs to the store as a whole, including the store manager? If you could just speak on what that's doing to allow that store manager to free up time to focus on end caps and to focus on areas of profitability within the store?

Herb Zarkin

Well it does just what you described. The MARM is really in charge of making sure that the organizations below the management level truly understand how to speak to a member, a potential member, and how to reinforce the membership; training, promoting, whether the cashier is doing the work, the service desk is doing the work, all these different categories.

This person has taken this burden away from the rest of the management. At the same time, this person has been helping that happen. We have been adding -- I won't say a burden -- an opportunity to the management through a lot of technological issues and a lot of ability to do things that they could never do in the past.

So today in the typical club, if you run into one of the managers walking around, they will have a Telxon gun on them, and this gun will trigger on a SKU and it will tell them not only how many they sold last week, how many they are selling this week, what the cost is, what the margin is, how much inventory they have on hand, how much is coming in, but they now have the ability to use that information to select and put items out on the floor themselves in a number of key areas -- certain key end-caps, the front of the club areas -- and they are all taking a great deal of pride in that.

They are also ordering special items that they now can do at the beginning of every month. They get together with their regional managers in their five or six district stores, and they pick items that they bookmark to get after, and they get special quantities of that in, and then they monitor that as well.

They are becoming truly entrepreneurial merchants at a lower level, but moving along in that area. That's something we have never asked them to do before. We've only asked them in the past to be, “do what we tell you to do.” Now we are asking them, what do they want to do. Or by the way, here are some things we think you ought to be doing and it's ended up with a very, very high level of confidence on their own part in participating and helping make a big difference in what happens in their own clubs from a merchandising point of view.

So it really is the beginning of a long process that takes some period of time, but it's allowed the management now to really get in and train and do the things that they want to do and produce the kind of results we are seeing. We think there is no doubt about  the sales benefit that is certainly coming from great selection and all the other things that we've talked about, but a good manager can make a substantial difference in any particular club.

So we now are allowing them to be even better managers than they were allowed to be in the past. I think the MARMs aren’t the only reason for that, but that's one of the good reasons we have gotten the benefit out of this.

Operator

Your next question comes from Robert Drbul - Lehman Brothers.

Robert Drbul - Lehman Brothers

Can you talk a little bit about your expectation for the toy category and how the trends have been and your expectations for the fourth quarter?

On the apparel side specifically, or even throughout the store, can you just talk a little bit about private label penetration, if you've seen the consumer trading down or trading into private label any more than you had in the past?

Herb Zarkin

Our private label, we have taken a number of SKUs out of private label because we weren’t happy with the quality of them or the packaging of them, et cetera. But our penetration is about the same as it was last year, if I recall correctly.

On the toy business, the toy business was doing well for a while. We had some very exciting items in it, producing some extra business for us. With all the recalls it has had an impact on the toy business, there is no doubt it. We understand that from what we hear around that the toy business, generally, it is not good at this early stage and we are like everybody else concerned about that because it is an important part of our business.

We do believe, though, when Christmas comes -- which it will come -- this is the longest distance we have between Thanksgiving and Christmas Day. It's the longest number of selling days in the course of a seven-year swing. We do believe toys will still produce a good result. Whether or not they are going to produce the kind of result we originally thought six to ten months ago is another story altogether, but every time there is a recall, it has some negative impact on the toy business, especially with so many of them all at one time.

Operator

Your next question comes from Christine Augustine - Bear Stearns.

Christine Augustine - Bear Stearns

I think one of the things that you've been working on is trying to boost your in-stocks in order to help business on the weekend. I was hoping if you could give us an update there?

The other question I had is on inflation. Are you seeing any increases in cost of goods sold for products that you're looking to import? Apparel or other imported products as you're looking at the forward buys for '08?

Could you tell us what the private label comp was in the third quarter?

Herb Zarkin

We've done a tremendous job in restocking the clubs for the weekend. We've done it by re-shifting the management, when we reorder, how we reorder, the schedules of the people that are working in the back of the clubs. We've had a tremendous improvement in being in-stock. We are seeing Sundays continue to be growing at a greater rate than any other day of the week, because it has become a very good shopping day for us across the board, and at the back of the club particularly.

So, we've made a lot of good inroads there with a lot of efforts both in terms of logistics department, in terms of the buyers, in terms of the clubs themselves, it's working out very, very well as far as that's concerned.

As far as inflation is concerned, we didn't see a lot of inflation up until recently and we haven't seen that much right this second other than obviously the price of gasoline. What we have seen now is a number of companies posting price raises for next year.

These are large CPG companies, petroleum products companies, Proctor & Gamble and people like that, Kimberly-Clark, and these are coming in. So far we see them, these are posted prices, and I'm not sure what they will flesh out at the end; around 6% on balance, some may be higher, some may be lower.

We did see inflation come in dairy products right at the beginning of this year, which we've talked about before. More in milk, the assorted other dairy products didn't seem to have quite has much inflation built into them as the basic milk product seemed to.

But we're pretty sure that we're going to see unusually high inflation, let me put it that way, next year based upon the price of oil and what else is going on. We've seen this in some non-food products as well. Anything that's got plastic in it, anything that's oil-driven, we've seen that as well.

As far as imports from overseas, I myself haven't seen much so far. Most of that merchandise is designed to enter the private label products, a good portion of it. It's designed for us, we can design the product to be “super duper duper” or we can just make it “super duper”. You have some control on what goes in the product and what the costs are going to be as far as that's concerned.

Your third question, I think had something to do with private label, but I forgot.

Christine Augustine - Bear Stearns

I was wondering if you could give us what the comps were for the private label in the third quarter. I think it was 9% in 2Q.

Herb Zarkin

I don't have the exact number. I think it was about flat. Keep in mind that we've reduced the SKUs by about 10% in the private label area. I think it was about flat. I have to get back to you with an exact number.

Operator

Your next question comes from Peter Benedict - Wachovia.

Peter Benedict - Wachovia

First, I'm interested in the slight contraction you saw in the Inner Circle renewal rates. When did you start to see that?  How does that compare to behavior that you guys witnessed historically when you've raised the fees?

Frank Forward

It is running historically with when we've raised fees in the past. Historically I think we've done it about three or four times and it has run in a similar pattern.

The thing to understand and the technical way we calculate it, it's done a little bit on a lag process because the renewals always come in, a good percentage of them come in one month, two months, three months late. So it's a consistent way we've done it since we've been a public company. I wouldn't make too much of it. It is a little bit short and we believe it's just due to the price increase of last year.

Peter Benedict - Wachovia

Fair enough. Can you talk about the traffic in average ticket assumptions behind the fourth quarter comp guidance and what you are thinking there to get to 4% to 6% for 2008? Thanks.

Herb Zarkin

The average ticket should be fairly high in the fourth quarter, because of the nature of what we sell -- televisions and Christmas gifts and electronics and things like that tend to have a higher ticket, plus the food selling with that, so much gifting and partying and stuff like that. We would expect to see a high average ticket transaction.

We would love to see and we continue to hope to see sooner rather then later an improvement in our average transaction. We think that's an important metric. It’s not the end of the world, but eventually, you have to have more traffic coming into your building. We are cycling through a whole bunch of competition and cannibalization. Most of our clubs have a competitor existing anyhow so it’s a little more difficult for us to get to as fast as we want to get to it.

I could get some more traffic tomorrow morning, but I wouldn’t be happy the way I did it. We're trying to do the right thing and run the business the right way rather than just arbitrarily run a promotion and promotion and promotion to get more people in the buildings so that I can say my traffic went up 1% or 2%. I really don't want to do that, I really want to build it the right way.

Hopefully that will happen next week, next month, next quarter, I don't know when for sure. I can't predict it. We will talk more about it come next spring as to where we are and where we are going to get. But right now, we are all aware of traffic and we also love to see the average ticket, which has been pretty strong.

In the fourth quarter we think that kind of mix will still be what it is going to be, we'll see. I don't expect a dramatic change, all of a sudden that we are going to have 5% more transactions in the next three months that we've had up until now.

Operator

Your next question comes from Chuck Ruff - Insight Investments.

Chuck Ruff - Insight Investments

Can you break out the impact of inflation on the same-store sales for the third quarter?

Herb Zarkin

As I said, we haven’t seen very much inflation with the exception of dairy, a couple of dairy products. So far it's been a miniscule impact. It's more of a going forward thing. We are starting to see a whole bunch of posted increases coming for the future and that will have a pretty meaningful impact on it and we’ve factored that into next year's plan a little more. We gave you a range of 4% to 6% comp increases because we are certain there is going to be a substantial impact going forward, but it's minuscule right now, It is not important enough that we can really identify it right now.

Chuck Ruff - Insight Investments

How much of that 4% to 6% next year is just inflation, do you think?

Herb Zarkin

I play around with this number all the time and I throw this number out and this is nothing scientific, I want to make it perfectly clear. If half of our business is done in products that are subject to inflation, the consumer products or gas business and stuff like that, and we get a 2% increase on those kinds of goods that means a 1% increase across the board on the balance, if we do $8 billion.

You can play that; I just picked an arbitrary number. It could be $8 billion worth of our sales that are all subject to inflation. I think inflation is going to have an impact and it could be 1% or 2% I think. I wouldn’t be surprise if its 1% or 2% next year on balance, bottom line effect.

Chuck Ruff - Insight Investments

Of your CapEx, how much of that is what could be termed maintenance CapEx, before new stores and expansion?

Herb Zarkin

We generally say about in the low $40 million is what we need to maintain the properties the right way and to maintain the systems and all that sort of stuff. That’s for the quarter, and that has been consistently around that number.

Chuck Ruff - Insight Investments

The guidance for next year, does it assume the tax rate stays about where it is now, 40% to 41%?

Herb Zarkin

Yes.

Chuck Ruff - Insight Investments

Can you tell us what you are assuming for shares outstanding?

Frank Forward

I would rather get into more of the detail at the year end conference call. Certainly we are assuming, like I mentioned, over the next 12 months to 18 months we would be buying back $150 million to $200 million in buybacks, so that obviously brings your numbers down. We’ll go through more detail at year end.

Operator

Your next question comes from Thomas Forte - Telsey Advisory Group.

Thomas Forte - Telsey Advisory Group

With the increased effort on being more competitive on price, I want to know if you are seeing a competitive reaction?

Herb Zarkin

We track ourselves pretty religiously on a regular basis now and we’ve been about where we want to be in relation to everybody else for the last several months. I don't see them, other than once in a while somebody will do something which is their choice to do, we think the relationship has been pretty stable for the last few months. We don't see anybody -- Costco and SAM's we are talking about. Against the supermarkets or the super centers, it's a little different.

We feel pretty good about it and we have narrowed the gap about where we want it to be. I think we may improve it a little bit more, but we are not looking to get into a price war with anybody. That doesn't benefit anybody and so we are not going to do that. But we are going to be comfortable where we are right now.

Thomas Forte - Telsey Advisory Group

With the improvement overall in the clubs performance, what would it take for you to increase the number of store openings in the future?

Herb Zarkin

Well, we'll talk more about that in the first call, but I believe that part of our model requires that of us, and it's important for us for a whole bunch of reasons -- nothing to do with economics but as well, there are a bunch of economic reasons to do it -- to open up more clubs and we are aggressively looking for more locations. We feel we'll probably step up in 2009-2010 -- calendar '09, calendar '10 -- up another notch or two, but we will spend more or about that now.

Right now we are looking at somewhere between 40 and 50 locations, all in marketplaces where we believe we could be successful. Not all markets will come through at any given time, nor will all of them come through.

The first year I wasn't anxious to grow any clubs to any great extent because I really want to make sure that the business is doing all it's supposed to do. Come next spring, we'll see how we're doing, which is good. We'll have this ability in the year after to bring clubs in and move them out, depending upon how well we are performing against our own standards.

We think we're on the way to getting to the standards that we want to get to on a regular basis but we've still got some work to do.

Thomas Forte - Telsey Advisory Group

I want to know if you view the category sales of cigarettes any differently than you have in the past, and if you're cutting back on the number of clubs that are selling cigarettes?

Herb Zarkin

We've cut back on a regular basis the number of clubs; selling cigarettes at cost or below cost is not a good way to run a business. We have not found those particular customers to be loyal customers on any other product line. They tend to buy the cigarettes and walk out the door. That may not be true in all cases. But we sell cigarettes where we're servicing the general consumer. If I had my choice, I'd be out of cigarettes tomorrow morning, but it's still a large volume and still to the casual shopper or to our Inner Circle member, they buy cigarettes, we have to have them for them.

I just think in the long run, we'll be out of the cigarette business, and we’ll be better off. The team, everybody would be healthier, but that's a social issue, which I don't want to get into, so all right?

Operator

Your next question comes from Gregory Melich - Morgan Stanley.

Gregory Melich - Morgan Stanley

With the store openings, the 40 or 50 you were talking about, are those basically in the markets you are in now or would you consider going into new markets?

Herb Zarkin

They're all in locations adjacent to or part of marketplaces where we currently exist.

Gregory Melich - Morgan Stanley

Can you just describe the CE business a little bit more this holiday, and how you're positioned for it? Are you seeing competitors change their warranty offerings, change their service offerings? Are you seeing margin degradation from others there, and because of it have you seen ticket and comp increases? Can you just describe that category a little bit more, and especially at holiday?

Herb Zarkin

We are very pleased with how we're positioned. We always have had a standardized policy. I think when Costco changed its policy a couple of months ago I was upset because I was telling our customers to bring it back to Costco, which didn't work out too well.

But we've always had a tight schedule on watching them bring it back within 30 days or when it has to go to a third party or what goes back to the company itself. So that's been consistent.

Our pricing has been attractive. We've gotten some very good products and we've seen the customers respond to it across the board. I don't believe we've seen anything dramatically different in this past few months than we have say six or eight or ten or 12 months ago.

Gregory Melich - Morgan Stanley

In terms of how the square footage is allocated, you are comfortable? That's the same as what it was last year?

Herb Zarkin

Well we've made better end-caps, we've made some stronger statements on this kind of merchandise. If you go in, you'll see some really strong end-caps with consumer electronics on it, or the Nintendo Wiis and stuff like that. GPS is obviously very important to us and the only thing in GPS is the prices are coming down like a rock. But we're selling it very, very freely; and iPods, stuff like that.  Those are very, very important.

But the digital picture frames are just taking off like crazy. That's a great item and the bigger size that we are bringing in now too, the customers seem to really like that. That's a new thing for their home and for their grandmothers and grandfathers to have it; it's a big thing.

Anything that's really nice and unique and different and serves a need like the digital picture frame, it's a wonderful, wonderful category and one that will explode over the next year or two to monumental proportions, quite honestly.

Operator

At this time I will turn the conference to Mr. Herb Zarkin for any additional remarks.

Herb Zarkin

Thank you very much, I appreciate it. We'll talk to you in a few months. Thanks.

Operator

That concludes today's conference. We thank you for your participation.

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Source: BJ's Wholesale Club Q3 2007 Earnings Call Transcript
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