Spinoff in Bentonville Revisited

A few weeks ago, I wrote an article about a possible spinoff of Sam's Club and took my approach primarily from the perspective of Wal-Mart's (NYSE: WMT  ) perspective. Several readers asked for some follow-up thoughts from the perspective of Sam's Club. How viable would the company be on its own? What are the advantages and drawbacks of being separate from Wal-Mart?

Well, let's take a look.

Can Sam's Club be viable on its own?
The answer is decidedly yes. By its very nature, the warehouse-club business compensates for low margins with very high sales productivity. Using public information, we can estimate earnings before interest, taxes, depreciation, and amortization (EBITDA) for Sam's Club as a standalone entity.

EBITDA for Warehouse Clubs, fiscal 2006

Metric

Sam's

Costco

BJ's

Sales

$41,582

$60,151

$8,480

EBITDA

$1,892

$2,146

$249

% to Sales

4.6%

3.6%

2.9%

Avg. Sales Per Warehouse

$73

$135

$51

Dollar figures in millions.
Source: annual reports.

Wal-Mart reports operating income for each of its segments, but it doesn't split out corporate overhead or depreciation and amortization by segment. Above I have allocated these two lines for Sam's Club as a percentage of total Wal-Mart sales -- not precise, but it gets us in the ball park. Comparing Sam's numbers to those of Costco (Nasdaq: COST  ) and BJ's (NYSE: BJ  ) , this method probably overstates Sam's EBITDA by 100-150 basis points. Profitability should be directly related to sales productivity. Since Sam's average sales per warehouse are much lower than Costco's, EBITDA as a percentage of sales should be lower, probably in the 3.0% to 3.2% range, a little higher than BJ's.

Assuming the low end of 3.0% EBITDA, a standalone Sam's would generate $1.29 billion in annual EBITDA. Take off $500 million for capital expenditures (20 new stores a year at $15 million to $20 million each, plus a hundred million or so for general corporate capital expenditures), and you have a business throwing off in the range of $800 million in cash flow per year -- definitely viable.

Merchandising synergies
Common wisdom would say that a retail business gains efficiencies with scale. While I agree with this assessment as a rule of thumb, it's obvious that Wal-Mart is anything but an ordinary company. I argued in my previous article that Wal-Mart would not lose merchandising synergies if it lost its Sam's Club volume. But would Sam's alone have enough buying clout to compete? Again, the answer is yes. At $41 billion in sales in 2007, Sam's Club would have been the 55th largest company in the U.S. and the eighth largest retailer, sandwiched between Lowe's (NYSE: LOW  ) and Safeway (NYSE: SWY  ) .

It is possible that Sam's could lose some buying synergies, but probably not a lot. Warehouse clubs buy different SKUs than general merchandisers do anyway -- a 60-count roll of toilet paper instead of a 12-count, for example. The warehouse clubs also sell a narrow assortment -- 4,000 base general merchandise SKUs excluding food, compared to more than 100,000 for a Wal-Mart Supercenter -- yet for many of those items, the clubs are the highest-volume sellers. For example, Sam's is the largest seller of Gatorade in the entire United States.

I think it's more likely that Sam's would gain on the merchandising side as a standalone entity. Wal-Mart currently tries to "manage" competition between the two in-house brands, but on its own, Sam's buyers could focus all of their energy on buying the absolutely best item at the best price in each category, as Costco buyers do. They could ignore the question of whether Wal-Mart also sells the same item, and they could also look beyond how to differentiate the two offerings. That would limit intercompany price competition.

Real estate
One of my readers brought up the point that many Sam's and Wal-Mart stores share the same real estate and even have a single co-branded gas station. Extricating the real estate should not be a problem. In the early days, Sam Walton leased most of his sites, but in recent years up to 80% of new sites are owned. The company manages the real estate portfolio as a separate entity, "leasing" the property to each operating unit. The simple solution in a spin-off would be to just continue to lease existing locations to Sam's Club. The Walton family would probably not want to give up a substantial portion of their domestic real estate holdings.

A separate Sam's would definitely lose clout in new-store economics. It doesn't have its own real estate arm. Opening only 20 or so new warehouse clubs per year would make acquiring the best locations more difficult. But every retailer in the U.S. must manage a real estate function, and Sam's could find plenty of able real-estate developers to farm this work out to.

I don't see the gas stations as an issue. At side-by-side locations, the gas station is usually owned and managed by Sam's Club, unlike stand-alone Wal-Marts, where the gas operation is leased to Murphy Oil (NYSE: MUR  ) . At these shared locations, the two brands have an agreement whereby Wal-Mart customers can buy gas at a discount with a Wal-Mart gift card. This sharing agreement would likely continue.

Free at last!
The greatest benefit for Sam's Club in a spinoff would be the freedom to chart its own course in the highly competitive retail world. Today, Sam's must follow what is in the best interest of Wal-Mart as a whole. For example, when push comes to shove, Wal-Mart gets the best real-estate site because a Supercenter is more profitable than a warehouse club.

Sam's must adhere to the corporate line in many other areas, including human resources, union issues, capital allocation, marketing, and overall corporate image. As a standalone entity, Sam's could decide what is in the best interest of its own shareholders, regardless of whether it fits with where the parent company wants to go. This freedom could result in a much stronger Sam's Club. And, in that same vein, it could be the best thing that has happened to Wal-Mart in a long time.

What are Sam's competitors up to?

Wal-Mart is a Motley Fool Inside Value recommendation. Costco is a Motley Fool Stock Advisor selection. Take a peek at either service -- or both, if you like -- free for 30 days.

Motley Fool contributor Timothy M. Otte surveys the retail scene from Dallas. He welcomes comments on his articles and owns shares of Wal-Mart of no other companies mentioned in this article. The Fool has a disclosure policy.


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