3/3/2010
By Brian Sozzi, Research Analyst

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This morning, BJ's Wholesale Club Inc. (BJ) announced its 4Q09 financial results.  As background, we reiterated our Sell rating and $28.00 price target on the stock prior to the issuance, citing generally unfavorable gross margin trends during the holiday season (weakness in discretionary departments and increased gasoline sales penetration), concentrated exposure to East Coast storm activity (72.0% of the storm base exposed to recent storms in our view) that could weigh on 1Q10 guidance (it did), and spending on "IT Roadmap" initiative that likely exacerbated soft gross margin trends.  Moreover, we cited longer-term considerations such as high reinvestment rates yet subpar returns, a catch 22 of sorts as BJ's Wholesale tries to ignite growth (IT spending vs. new unit growth off the East Coast), and strong competitive forces from better positioned rivals (Sam's Club, Costco).

On that score, we were absent the element of surprise by the company's rather lackluster 4Q09 performance and its 1Q10/FY10 EPS guidance.  We believe the miss ex. items were indicative of:

* Sales miss in discretionary merchandise departments.
* Increased competition in fresh food arena.
* Increased penetration of gasoline sales given higher prices.
* Gross margin was flat y/y at 9.34%, missing consensus by 7 bps.
* Lack of expense discipline, reflecting spending on "IT Roadmap" plan and club renovations.

Comparisons to Costco's results out this morning:
* BJ's Wholesale missed on adjusted EPS; Costco missed on adjusted EPS.
* Both companies showed sizable y/y inventory increases (currency related or something more?).
* BJ's Wholesale had a slower rate of growth in membership fees (3% versus 8%).
* BJ's Wholesale gross margin was flat; Costco had expansion north of 20 bps; indicative of the differences between the two companies sales mix.

We are reiterating our Sell rating and $28.00 price target on BJ's Wholesale, representing a valuation of 10.98x (currently valued at 13.56x our estimate) our downwardly revised EPS estimate for FY10 of $2.55 (previous: $2.63).  Or, a multiple of 10.01x our lowered FY11 EPS projection of $2.78 (previous: $2.82).  In both instances, we have valued the company using multiples below the historical average, our discount retail sector coverage average, and S&P 500 as we have difficulty constructing a growth story from BJ's Wholesale, thereby warranting a higher valuation. 

Although the near-term impact on earnings from investment spending is receiving attention (note these upgrades should have been undertaken years ago), we believe too much focus on the subject clouds the underlying story of BJ's Wholesale.

* Strategy of infilling stores on the East Coast to become dominant in food seems to us a diminishing return proposition.  For one, self cannibalization is increasing.  Second, we do not believe BJ's Wholesale is gaining a significant amount of share as a result of competition from improved perishable food departments at Costco, Wal-Mart (WMT), and even Target (TGT).  In an age of one-stop shopping, customers are inclined to frequent stores offering more compelling overall assortments; Costco and Target for example have stronger softlines departments and again, improved fresh food departments.  We also wonder about the point of differentiation of BJ's Wholesale, seeing as 70% of its assortment could be found at supermarkets.

Other considerations
* Small penetration in private label goods (about 11%; Costco at 27%), competition intensifying, cost prohibitive nature to expand beyond East Coast, high reinvestment rate yet subpar returns, less stable operating margin relative to Costco.

Brian Sozzi
Wall Street Strategies