Warehouse Clubs Find the Sweet Spot

Costco and BJ's post solid sales growth even as other merchants falter. How have these big-box behemoths sidestepped the retail slowdown?

It's been a tough winter for U.S. retailers with one big exception: Warehouse clubs are busy despite the slow traffic at nearly every other retailer, as new results from Costco Wholesale Corp. (COST) and BJ's Wholesale Club (BJ) showed Mar. 5.

Costco saw same-store sales jump another 7% in February, while its smaller rival BJ's, which focuses on the northeastern U.S., saw same-store sales rise 5.9%.

BJ's and Costco are among the first chains to report February sales, but don't expect other retailers to report similar success. Wal-Mart is expected to post a 1.1% increase in same-store sales, but sales at almost every other major chain are expected to fall, according to analyst predictions compiled by Reuters Estimates.

Target (TGT) should fall 0.3%, while analysts expect a 4.1% decline at Kohl's (KSS), a 2.9% decline at the Gap (GPS), a 1.9% drop at J.C. Penney (JCP) and a 3.0% decline at Macy's (M), Reuters Estimates says.

"Consumers are feeling the heat on a number of fronts," says Ken Perkins, president of Retail Metrics. The full force of a housing slowdown is kicking in. Higher inflation, including rising gas and food prices, is hurting, and many consumers are worried about their jobs as recession fears mount.

At BJ's, Costco and their rival, Sam's Club, which is owned by Wal-Mart, customers buy yearly memberships to get access to food and other goods, ranging from T-shirts to wide-screen televisions, priced at steep discounts.

Warehouse clubs "become more attractive [as] consumers become more price-sensitive," says Georges Yared of Yared Investment Research.

The clubs can avoid some of the broader consumer slowdown by focusing on staples — items like food and home supplies that consumers must buy even if they avoid spending on luxuries.

As Richard Galanti, Costco's chief financial officer, put it to analysts Mar. 5, "People still have to eat."

A certain amount of inflation can also help the discount warehouses, execs and analysts say. First, consumers seek out the clubs' gas, often sold to members at discounted prices. Second, shoppers want to save gas by making fewer shopping trips but buying more with each visit. That makes the warehouse's sales of bulk food attractive to shoppers, Perkins says.

"Where inflation is driving up prices, BJ's helps consumers stay within their budget," Herbert Zarkin, BJ's chairman and chief executive, told analysts Mar. 5.

The strong sales have helped both chain's bottom lines.

On Mar. 5, BJ's posted earnings of 80 cents per share last quarter, up from 18 cents a year ago. While February same-store sales were up 5.9%, last quarter's same-store sales rose 5.4% and total sales were up 1.9%. The chain operates 175 clubs in 16 eastern U.S. states.

"The recovery story is in full swing," wrote UBS (UBS) analyst Neil Currie. Standard & Poor's equity analysts upgraded the stock from "hold" to "buy." (S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies.)

Costco's earnings per share rose 12% from a year ago to 74 cents. That mostly meeting analyst and investor expectations, though some were worried by higher expenses and slightly narrower profit margins.

Costco shares fell 2.5% to 60.83 on Mar. 5. The stock is up 10% in the past year. BJ's shares, up 15% in the past year, moved 6.7% higher on Mar. 5 to close at 35.52.

No one, including BJ's and Costco executives, seem to think the chains are completely insulated from the broader economy or a deep consumer slowdown.

For example, says John Langston, an analyst at Hodges Capital Management, higher gas prices helped Costco's U.S.

same-store sales, while the weak U.S. dollar helped boost its sales figures at international stores. Costco operates 533 warehouses, including 391 in the U.S.

"These are unusual times for retailers and no one really can predict how consumer spending is going to be affected by inflation or any other economic forces between now and the end of the year," BJ's Zarkin said.

While sales were strong overall at BJ's, they were weak in areas like housewares, appliances, furniture and jewelry. Costco's Galanti noted similar trends. Even within meat, there was even a slight shift from pricier beef to cheaper chicken, he said.

In the long-term, the business model of the warehouse club has strong advantages.

Big box discounters like Wal-Mart or Target also offer low prices, but Yared says warehouse stores have an advantage. A Costco warehouse might have only 10% of the number of items that a Wal-Mart store sells. Thus, Yared says, Costco is "laser-beam focused" on top sellers, while Wal-Mart has "a lot of merchandise that just isn't selling."

Also, requiring customers to buy a membership card seems to boost customer loyalty and spur extra spending. Some attribute the extra spending to clubs' lower prices, but recent research by Michael Norton of Harvard Business School and Leonard Lee of Columbia Business School suggests shoppers' motivations might be more irrational. "The presence of membership feeds can lead consumers to infer a 'fee [to] savings' link, spurring them to increase their spending independent of the actual savings afforded by such clubs," Norton and Lee wrote recently.

In the short-term, the threat of a U.S. recession looms over all companies, including Costco and Bj's. Perkins notes that some help for is on the way for U.S. consumers, in the form of a federal government stimulus package and lower interest rates. But there is also real worry about higher unemployment and a slowing economy.

"The headwinds seem to be outweighing the stimulus, but at least there are some things in the pipeline," he says.

Warehouse clubs might be hurt less than other retailers by a slowdown in the U.S., but they could still feel the chill if consumers continue to tighten their wallets.

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