Investment Thesis

In the shadow of the well-established and high-performing retail giant, Costco, stands BJ’s Wholesale Club Holdings (NYSE:BJ), a comparable business operating on a smaller scale. Remarkably, over the past five years, BJ’s has not only delivered superior returns in its share price but currently trades at less than half the multiple of its larger counterpart, Costco.

This article aims to delve into the intricacies of BJ’s business model, highlighting its unique benefits and competitive advantages. A thorough analysis of its position in the market concerning similar businesses will be undertaken, shedding light on the exciting prospects for future growth. To cap it off, a comprehensive valuation will be conducted to articulate why, at the current price, BJ’s Wholesale Club presents an attractive investment opportunity.

Business Overview

BJ’s is a membership-based warehouse club that operates in the US. It offers a variety of products, including groceries, electronics, furniture, appliances, and more, often in larger quantities and at discounted prices compared to regular retail stores. BJ’s is similar to other warehouse clubs like Costco and Sam’s Club, where customers need to acquire a membership to unlock the savings and discounts available at the wholesale club, and that’s a fundamental aspect of this kind of business.

Scale Economies Shared

The concept revolves around offering products with minimal or no profit margins, allowing consumers to benefit by purchasing items at lower prices, as BJ’s absorbs a significant portion of the costs. However, to access these advantages, consumers must pay for a membership, which carries high margins for BJ’s. This is because the membership is a simple plastic card with relatively low production costs, and its value lies in granting access to the provided discounts, which allows consumers to end up amortizing the cost of the membership through the discounts obtained in the store.

This arrangement proves beneficial for both the company and the consumer. As BJ’s expands, it can offer its products at more competitive prices. Additionally, with more members subscribing to the company, improved profit margins and greater scale are achieved for BJ’s. This dynamic aligns with what Nick Sleep refers to as “Scale Economies Shared”, as the growth of one entity mutually benefits the other – in this case, BJ’s and its customers.

Competition

As evident, scale plays a pivotal role in this business model, and I view it as one of the primary risks in the thesis. Currently, BJ’s faces formidable competition from two industry giants, Sam’s Club (owned by Walmart) and Costco, both nearly three times larger in terms of the number of wholesale clubs in the United States. Competing directly with these giants poses a significant challenge and could impede BJ’s growth unless it can secure a substantial market share. Given subscription renewal rates exceeding 90% in these business models, capturing market share from Costco or Sam’s Club necessitates not only a superior reputation or brand power, which is not easily achieved but also more compelling prices that justify a switch to wholesale clubs.

Currently, there is a big difference between the scale of BJ’s and that of Costco and Sam’s, as well as in revenue per club (RPC), so the company’s mission will be to close this gap in scale and profitability.

Moreover, I believe the concept is not overly complex to replicate for large-scale supermarkets. In Central America, there is a player named PriceSmart with a similar business model, and in Mexico, City Club, owned by the Soriana supermarket chain, follows a comparable approach. It wouldn’t be surprising if other supermarket chains or retail stores, such as HEB or possibly Target, also expressed interest in tapping into the advantages offered by this business model.

The Glass Half Full

If we approach this from an optimistic standpoint, we can emphasize the significant opportunity this presents for the company. Considering the high retention rates among wholesale club members, having already reached one-third the scale of Sam’s and Costco, which have the first-mover advantage, reflects a business model that also provides value to its customers.

Presently, the company boasts just over 7 million members, in contrast to Costco’s 56 million and Sam’s Club’s 52 million. Moreover, the membership fee is $5 cheaper than Costco’s. Therefore, concentrating on expanding the member base and subsequently adjusting membership prices with an established customer foundation is a promising avenue for future growth. Additionally, it’s noteworthy that the company exhibits the highest EBITDA margins in comparison to its peers, and the percentage of memberships relative to sales is lower than that of Sam’s, indicating the potential for even higher margins.

In a scenario where the company manages to double its member count and raises prices to $60 USD, this could result in generating close to $850 million in pure profit (14 million hypothetical members multiplied by the membership price of $60 USD) since the cost of raising prices is zero and profits generated by memberships have margins of almost 100%.

Key Ratios

Since 2016, revenue has experienced a modest annual growth of 7%, while Free Cash Flow has seen a more substantial increase at 35% annually since in FY2016 they generated $47 million of Free Cash Flow and during FY2023 they reached $390 million. This is attributed to the rising revenue from memberships and an improvement in margins from product sales within the wholesale club.

In 2017, the EBITDA margin for product sales was approximately 1%, and it has since increased to nearly 3%. Although still relatively low, this upward trend is instrumental in the company’s efforts to expand its profit margins.

The EBITDA from product sales was computed by subtracting the membership revenues from the company’s total EBITDA. This calculation is based on the assumption that the product sales segment generates 100% of its revenue in EBITDA, given that the membership costs primarily consist of the plastic cards that grant access to members.

The company is directing a growing percentage of sales into capital expenditures to expand its warehouse presence, capitalizing on the evident geographical expansion opportunities. Between 2018 and 2020, the company added warehouses at a rate of just one per year. However, in 2021, they constructed four new BJ’s, followed by five in 2022, and a notable nine during 2023. This pattern suggests the company’s readiness and comfort in pursuing further expansion.

An encouraging development is the resolution of the debt issue. Over the last five years, the company financed 60% of its operations with debt, issuing $5.5 billion. While this initially led to high leverage ratios in 2019, almost 4 times EBITDA, the net debt has now reduced to 3x EBITDA. Although still relatively high, this level is more manageable.

The resolution of the debt issue required significant resources, with $7.3 billion allocated between 2019 and 2023 to repay debt. This strategic capital management decision appears to have positively impacted the company’s growth trajectory. It seems they paused the construction of new BJ’s during this period, and the recent acceleration in growth indicates prudent financial management to avoid excessive debt accumulation, thus preserving and enhancing the company’s overall value.

Valuation

To evaluate the potential performance at the current price, I will project revenue by products and revenue by memberships. An essential factor to consider is the company’s historical pattern of increasing membership prices every five years, with the last increase occurring in 2017, taking the fee from $50 to $55. Given this, a potential increase to $60 within the next 12 months seems plausible.

Anticipating a more conservative growth rate for net sales, possibly around 5%, compared to the nearly 8% growth observed from 2017 to 2023, and projecting membership increases at a rate of 8% until reaching 10 million members, significantly less than Costco’s current almost 60 million. Factoring in a $5 increase in the membership fee, Membership Fees could grow almost 10% compounded annually, contributing to a total revenue growth of 5%.

Assuming that the EBITDA margin for net sales reaches 3.5%, and considering that memberships have margins of around 100%, this would result in an EBITDA margin of 6% within five years. Applying a multiple of 12x EBITDA, consistent with the average multiple of the company and similar firms, the projected share price in five years could be around $130, implying a potential return close to 15% annually when buying at the current price.

It’s worth noting that comparable business models with operations in Latin America often trade at considerably lower multiples. While Walmart and BJ’s have maintained multiples of around 12x EBITDA, Costco, as a market leader, commands a higher multiple. However, considering 25x EBITDA as excessive, and aiming for a more conservative valuation, not exceeding 20x EBITDA, the decision not to use Costco’s multiple as a reference seems justified.

Final Thoughts

The company has demonstrated its ability to compete with industry giants Costco and Sam’s Club, despite its smaller scale. Achieving 7 million members in an industry where customer retention is high reflects the appeal of BJ’s offerings. The management’s adept capital allocation has been evident in strategic decisions, knowing when to prioritize growth and when to solidify the company’s financial position.

Moreover, the current valuation appears to present highly attractive returns with conservative assumptions. Reaching 10 million members seems feasible, especially considering the company’s strong presence on the East Coast, where only populous states like Florida, New York, New Jersey, and Massachusetts already represent almost 60 million potential members. Once this milestone is reached, the company stands to benefit from operating leverage, with each new member in close proximity to a BJ’s having a low incremental cost.

In the event of better-than-expected performance, a re-rating to 15x EBITDA would not be unprecedented, potentially leading to even higher returns. Considering these factors, BJ’s appears to be a ‘buy’ and represents a compelling opportunity in a robust business with substantial growth potential. However, it’s crucial to acknowledge the formidable strength of competitors and the complexity of establishing differentiation in this particular business model. In a landscape where products are fundamental consumer staples, the key differentiator often rests in possessing a superior reputation and brand compared to rivals and in this aspect Costco has the advantage of being the first-mover. It remains imperative to closely monitor the company’s ability to sustain growth in the number of members without compromising profitability.