Retail's Retreat Serves Up Big Chance for Warehouse Clubs

Looking for Santa? Check out your local wholesale club.

As layoffs mount and consumers cut back, retailers are forecasting their weakest Christmas in a decade. Analysts expect plunging profits across the industry to punish the stocks of the upscale and specialty retailers that typically cash in on shoppers' holiday largess. Notably, Federated Department Stores (FD Quote), the operator of Bloomingdale's and Macy's, expects flat fourth-quarter same-store sales; its shares have fallen more than 20% this summer.

Share Prices of Discount Retailers Costco and BJ's Remain Steady in 2001

The lone bright spot is the wholesale club business. Deep discounters such as Costco (COST Quote) and BJ's Wholesale Clubs (BJ Quote) have tended to traffic in unglamorous, marked-down merchandise that fails to elicit visions of dancing sugarplums. But with economists predicting retail's worst fourth quarter since the early 1990s recession, these companies are poised to capture a growing chunk of your Christmas change. That, observers say, could set off a year-end rally in these shares.

"The warehouse clubs have a big opportunity," says Todd Slater, an analyst at Lazard Freres. "You don't think of these as stores to buy Christmas gifts, but this year they will probably outperform the rest of retail."

Warehouses have traditionally pushed more utilitarian, less lucrative items than department and specialty stores; think wrapping paper and aluminum pans rather than diamond necklaces and cappuccino makers. But this year, as consumers tighten their belts, the clubs could be a hot spot to buy gifts as shoppers worry less about the latest gimmick and more about value for the dollar.

"I think their model is less selection, but very sharp prices, very attractive prices on the selection they do have," says Darrell Rigby, a director at consulting firm Bain & Co. who specializes in corporate retail strategy. "In an economy like this, as long as they select relatively attractive merchandise, I think customers will be interested."

Better still, a year ago these companies posted sales numbers that were solid but unspectacular, meaning this year's figures should look good by comparison. Strong comparisons often ignite stock movement.

"Wholesale clubs represent one of the most attractive sectors in retailing," says Robertson Stephens analyst Bill Dreher, who covers BJ's, in a recent research report. He notes that the clubs are growing at a 15% annual clip, three times that of the industry as a whole. (He has a buy rating on BJ's and his firm doesn't have a banking relationship with the company.)

Indeed, consider the most recent same-store sales figures: In July, sales at apparel retailers declined 4.2% and those at department stores dropped 0.7%. But BJ's comp sales rose 3.7% and Costco's jumped 4%.

July Same-Store Sales

* Figures according to First Call/Thomson Financial

The wholesalers' performance has improved as the economy has slowed. Of course, that's nothing new: Tough times, or at least the threat of them, have helped the warehouse clubs before. They enjoyed same-store sales jumps of 15%-18% in 1999 as nervous consumers stockpiled goods in advance of Y2K, notes Slater. Last year, however, sales advanced just 1% as the economy ripped along at a torrid pace well into the fall. (Slater has a hold rating on BJ's and an outperform rating on Costco, and his firm hasn't done any recent underwriting for either company.)

As a result, BJ's shares are up about 33% on the year, yet trading at a relatively modest 21 times next year's estimated earnings, according to Thomson Financial/First Call. Costco, which has seen its shares tread water this year, trades at 26 times next year's earnings targets. With both companies expected to show 15%-17% sales growth in coming years, the time could be right to ride the wholesale club wave. At least when it comes to Christmas, anyway.

"During good times it is interesting to have a selection of 25 different VCRs to choose from," Rigby says. "In tough times if there are two or three, but they are good products at a very attractive price, that's all I need."