Warehouse Clubs: When the Going Gets Tough...

The slowdown hasn't slowed down Sam's Club and Costco

On a sultry June afternoon in Plano, Tex., the bargain hunters are out in force. It's the grand opening of a new Sam's Club, and shoppers are swirling around a 20-carat, $1.2 million diamond, snacking on fresh Alaska salmon, and scoping out good deals. Geri Ashley, mother of two, chooses a pair of trendy, rainbow-hued "bubble" tops for her daughter. And why not? They cost $15.75 each, a third of what they'd fetch elsewhere. Says Ashley: "Little things like this draw you in."

That's music to the ears of warehouse clubs. With most retailers enduring the worst sales drought in a decade, the likes of Sam's--where consumers and businesses pay annual fees ranging from $30 to $100 to shop--are still packing them in. The clubs' well-honed formula of ultralow prices and surprise deals on selected upscale merchandise is helping Sam's (part of Wal-Mart Stores), Costco Wholesale (COST ), and BJ's Wholesale Club (BJ ) steal business from just about every other retailing segment. And the addition of fresh food and gasoline is bringing customers in more often.

The weaker economy is hurting the clubs far less than others. In May, same-store sales at the three principal players surged an average of 4.9% from the year before. Compare that with the anemic 1.7% gain posted by a broad index of retailers tracked by Lehman Brothers Inc. "The strong numbers show consumers are laser beam-focused on finding the best value," says analyst Emme P. Kozloff of Sanford C. Bernstein & Co. "And the absolute best value is [at] a club."

Now, as the clubs seek to press their advantage and step up ambitious expansion and renovation plans, the stage is set for increasing battles between Costco and Sam's. Sam's executives believe Costco is finding it tougher than expected to lure customers in Sam's strongholds with gimmicks such as free memberships. Costco insists its new stores are meeting performance targets.

Nonetheless, the accelerated growth is causing some short-term earnings pain for the 363-store chain. Costco plans to add 32 stores worldwide in the fiscal year ending Sept. 2, and another 35 next year. But new clubs typically are unprofitable in the first year or two. Also, 20 of the 27 U.S. stores being added this year are in new markets, so they're more expensive to start up. The Issaquah (Wash.) company has posted two quarters of earnings declines, and analyst Kozloff expects earnings this year to fall about 6%, to $596 million, on 9% higher revenues of $35 billion. Insists Costco Chief Financial Officer Richard A. Galanti: "We know long term that [the expansion] is the right move."

UPSCALE. That may prove true. But Sam's has been matching or beating Costco's U.S. same-store sales gains almost every month since September. Partly, that's because Costco is ahead in adding "ancillary" departments such as optical shops and pharmacies, so it faces much tougher growth comparisons with a year ago. But Sam's, with 485 U.S. stores, has benefited from renovations and from adding better merchandise, such as Birkenstock sandals and Ralph Lauren sheets, aimed at higher-income customers. It also helps that most of the 25 new Sam's stores this year are in areas where it already has units. Operating profits for the division jumped 10.8% last year, to $942 million, as sales rose 8%, to $27 billion. "There isn't a more exciting place to shop than a club," says CEO Thomas R. Grimm.

For all their intense rivalry, Sam's and Costco figure they both have room to grow. Many analysts agree. Brian S. Postol of A.G. Edwards & Sons Inc. says the number of U.S. clubs could climb another 75%, to about 1,500, before investors need to worry about saturation. Still, the retailers need to keep innovating to maintain their appeal, says food industry consultant James M. Degen. No wonder Costco is testing glazed doughnuts and gourmet popcorn made on site, while the new Sam's in Plano offers online shopping kiosks. As long as they keep luring shoppers with low prices and fresh ideas, the clubs should manage this downturn better than most of their retail rivals.

By Wendy Zellner in Plano, Tex.

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