Specialty BJ’s Wholesale Club - BJ

BJ’s Wholesale Club - BJ

Buy – Target: $ 36.00

Current Price: $ 27.75

Company Introduction: BJ’s Wholesale Club is a warehouse club operator on the East Coast of the United States. Headquartered in Westborough, , BJ’s started their business in New England in 1984. Now, they own and operate 215 high volume warehouse clubs, 135 with gas stations, serving 5+ million members in 16 states. Investment Thesis

• Membership fee income (which represents 50% of adjusted EBITDA) has grown at a CAGR of nearly 8% since 1997, while membership renewal rates reached an all-time high of 86% in the past 2 quarters. Recently, management has made significant investments in IT and data analytics to emphasize a better customer experience, cost discipline, product assortment and gross margin improvements. We expect BJ’s membership base to continue to outperform peers, as management continues to build its customer acquisition and retention strategy.

• Every brick-and-mortar retailer has been forced to create an e-commerce solution to defend v themselves from Amazon, specifically Amazon Source: Bloomberg, JWC Research Fresh in this case. BJ’s has a unique strength Daily Chart landing their niche between traditional grocers/ and other warehouse club peers, mainly Wholesale (COST). BJ’s has a pricing strategy that generates better gross margins than wholesale peers like COST; while broadly maintaining a 25% pricing advantage over typical grocery stores. Relative to COST, BJ’s offers a wider product selection, fresher SKUs and smaller pack sizes. This strategy distinguishes them, provides shopper convenience and drives more frequent traffic to stores.

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Recent Developments / Analyst Thoughts

Analyst Thoughts:

BJ’s Wholesale Club went public on June 28th, 2018 at $17 per share. The stock promptly rallied ~30% to $22 per share. We believe the wholesale club industry presents a long-term opportunity for investors. BJ’s is at the early stages of growth with better margin opportunities relative to Costco (COST).

It is this distinction that has led us to recommend BJ over COST, although we believe both to be viable long-term opportunities.

BJ’s is currently located along the East Coast only and targets households with an average annual income of ~$75,000. BJ’s is benefiting from some Sam’s Club store closings.

Source: KR Filings, BJ Filings, Business Strategy: COST Filings Instead of announcing an aggressive store expansion plan after going public, BJ’s has elected to focus on better customer experiences to improve member retention, cost discipline, product assortment and gross margin improvements. In 2017, YoY net sales increased 3.3% as BJ’s shifted to a clearly defined private label brand strategy for improved gross margins. We believe the new product mix will drive more frequent traffic. BJ’s plans to open 15-20 new clubs over the next few years.

Their six (6) existing distribution centers, have the capacity to support 100 new clubs. Thanks to the data-driven marketing approach they are implementing, BJ’s is well positioned to utilize their proprietary consumer behavior data, leading to more profitable baskets, effective operations and new store selection, while simultaneously complimenting supplier renegotiations, competitive contract options, and brand switching. BJ’s membership renewal rates have been trending higher since FY16 (84% in FY16, 85% in FY17, 86% in FY18). We believe this trend will continue until they reach a sustainable 90% retention rate. www.JWCResearch.com Page 2 September 18, 2018

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BJ’s Wholesale Club - BJ

Company Description Figure 1. BJ’s Footprint BJ’s Wholesale Club is a warehouse club operator on the East Coast of the United States (Figure 1). Headquartered in Westborough, Massachusetts, BJ’s started their core business in New England in 1984. Now, they own 215 large-format, high volume warehouse clubs, 135 gas stations, and they have 5+ million members in 16 states. BJ’s focuses on perishable grocery, while also offering general merchandise such as apparel, electronics, home goods, seasonal merchandise, as well as ancillary services such as tire installation, vision care, travel and insurance at an attractive value. Their 2-tier annual membership fees include their base Inner Circle Membership at $55 and Perks Rewards Membership at $110 with additional value-enhancing features.

Industry Overview

Source: Company Presentation Warehouse Club: The Wholesale club model is a specialty retail store format that sells limited products at a discount, to the conventional supermarkets or grocers (Figure 2). They Figure 2. BJ’s vs. Amazon Fresh usually limit the profitability on individual products and pass on the savings to their members. Profitability comes by charging members an annual membership fee. Packaged goods often come with larger sizes, at a lower price, and BJs can offer a treasure hunt experience.

Although targeting medium to high income households, the clubs are usually located in price-sensitive suburban neighborhoods. Warehouse clubs can take advantage of their scale to provide high-quality goods at attractive prices and offer strong private-label brands. The top-three US warehouse clubs generally have operating margins of around 2%-4%.

Now almost every brick and mortar retail store Source: JWC Research, Company Data, Amazon has some e-commerce solution to defend themselves from Amazon. BJ’s leadership relies significantly upon their data driven information to expand their customer base, select new club locations, improve customer experience and broaden revenue streams, a trend seen throughout the industry.

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BJ’s Wholesale Club - BJ

Industry Overview Figure 3. Comparable Club Sales

(continued)

E-commerce: E-commerce has been a threat to brick-and-mortar stores since the Amazon era. On top of the Prime membership which offers unlimited 2-day free shipping and their traditional books and media businesses, Amazon has broken into several fields including Amazon Fresh. However, discount retailers like warehouse clubs, compared to department stores, as well as regular priced retail stores, are relatively immune to the invasion of e-commerce because of their unique strength on pricing and private brand penetration.

On the online order delivery side, BJ’s has followed the lead of Costco and ’s Sam’s Club for partnership with Instacart to offer same-day Source: Company Data delivery, even in as little as an hour. Since BJ’s has so much more fresh SKUs on grocery, this e- commerce solution of same-day delivery, add-to- cart coupons and pick-up in store option helps BJ’s to compete with Amazon Fresh/Whole Food business. Plus, after losing the $299 annual membership option, now Amazon Fresh is only available for Amazon Prime member ($12.99/month) for an additional $14.99/month. In this case, Amazon members pay significantly more as an exclusive member for the same basket of products for a worse price (Figure 2). Eventually, all food & staple retail stores will have the capacity to handle online shopping for customers like Amazon, which triggers momentum for the entire industry.

Figure 4. U.S. Warehouse Club Market Sizes (in billions)

Source: Company Presentation

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BJ’s Wholesale Club - BJ

A Quick Look at Operations

Growth Strategy: As a new public company, BJ’s gross profit margins is the highest among BJ’s has implemented several initiatives to the top three wholesale club peers. Gross profit generate more membership fee income, and margins are expected to stay flat at around 16% net sales by growing their customer base, due to freight and labor costs from food and improving member retention and historically staples. increase membership fees every five years. Competitive Edge: Differentiating from other This includes improving shopping experiences membership-based wholesale clubs that also by investing significantly into designing come in with promotional pricing advantage, features on the apps that allow the customers low-cost operations, and bulk product offering. to pick up in the club, add-to-cart coupons, BJ’s is tilting towards fresh grocery, smaller express scan and same-day delivery offerings. pack sizes and wider stock keeping unit (SKUs). Since membership fee income only accounts for Given their Northeast geographic focus and about 2% of the total revenues, net sales from the product mix will be the key to drive top-line smaller store format, BJ’s hopes to drive traffic from lower income families while urging more growth. frequent foot traffic thanks to their lower From FY2016 to FY2018, although they only product prices, slightly lower annual opened 2 additional stores, comparable club membership fees and a wider product sales have rallied from -4.2% to 0.8%, a 5% assortment. We believe they have a unique club swing (Figure 3). To drive bottom-line profit model that enables more convenient shopping growth, management with supplier-relationship experiences through omni-channels and more experiences, are pushing cost savings through manageable club sizes for store expansions. The negotiations and private label penetration recent IT investments will provide important (Figure 5). The penetration rate rose from 10% data and values to the new store selection. We of total merchandize sales in FY2012 to 19% in expect BJ’s to continue to benefit from tailwind FY2017, which lowered costs of goods sold by of peer store closures and expand their footprint streamlining portfolios of 13 private label in populated areas. brands to 2 focused brands-Wellsley Farms and

Berkley Jensen brands. This might affect short- term net sales but improve gross margins in the long run.

Figure 5. Cost Savings

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BJ’s Wholesale Club - BJ

Management JWC Valuation

Our View: Leadership has been through a lot of Valuation: Our price target of $36 is derived senior management changes and hires over the primarily from the average of EV/EBITDA last two years. They have newly hired, promoted valuation and our discounted cash flow (DCF) or added responsibility for all 13 of their valuation (Figure 6). We utilize a 2019 executive officers, including Chris Baldwin as EV/EBITDA multiple of 10.5x. For DCF, we use a President and Chief Executive Officer, in the hope weighted average cost of capital of 8.2% and a to add experience in consumer-packaged goods, perpetual growth rate of 2.80%. and digital, that align well with their growth strategy and value proposition. We believe that Capital Structure: BJ’s has a market cap of in a challenging retail environment, the ~$3.8 billion and $73 million in cash for FY2018. leadership’s focus on customers and data-driven As of February 3rd, 2018, they have long-term initiatives will greatly enhance members’ debt of $1.9 billion and higher leverage than experiences and convenience, thus more likely to peers. The company used net proceeds from the attract new members and retain existing IPO to repay $623.2 million principal plus $10.2 customers. million of accrued interest. We expect them to

Management has made significant progress on continue to pay down debt as they are growing both enterprise-wide cost discipline and their business. improved profitability. During FY2016 and 2017,

they negotiated over $260 million in expected annual procurement savings. The CPI initiative will be a great addition to their already low-cost warehouse operating model, with high inventory Figure 6. JWC Valuation turnover, as well as an efficient distribution system, that can accommodate an aggressive new store opening campaign, where management believes they can add value.

Source: JWC Research, Bloomberg www.JWCResearch.com Page 6 September 18, 2018

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BJ’s Wholesale Club - BJ

Risks

Regional Concentration: BJ’s existing wholesale clubs are only located on the East Figure 7. Estimates & Key Data

Coast. They operate in the core New England market and have high regional concentration. The New England’s market accounts for nearly a large portion of BJ’s total store count (50/135 stores). A concentrated footprint and customer base results in disadvantages relative to peers during winter months due to potential disruptions thanks to inclement weather conditions while sales in the South and on the West Coast will likely be stronger.

Higher Financial Leverage: The company has higher financial leverage than the peers. Their Debt/2019 EBITDA of 3.53x is higher than that of Costco and Walmart. Although Moodys has upgraded their credit rating from B3 to B1 due to management using proceeds from IPO to repay a $625 million second lien term loan, the business’s financial sponsor ownership could continue to control a majority of voting power and aggressive financial policy is likely to impose Source: Bloomberg, JWC Research business risk.

Competition: Wholesale clubs are a special type of discount retail stores. The discount retail industry is fragmented, and they face competition from peers. BJ’s is competing with other membership-based warehouse clubs such as Costco and Sam’s Club, mass merchants like Walmart and Target, and conventional grocery stores. Even though BJ’s offers a broad assortment of products at a discount, if they fail to maintain their pricing advantage, lose their grocery focus or have trouble executing the store expansion plan, it would have an adverse effect on their operations.

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BJ’s Wholesale Club - BJ

JWC Rating Systems

Buy: The stock’s total return is expected to outperform the S&P 500 over the next 12 months. Avoid: The stock’s outlook and drivers are too unpredictable. This stock should be avoided. Sell: The stock’s total return is expected to materially underperform the S&P 500 over the next 12 months.

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