The Bull and Bear Case for BJ's Wholesale Club Stock

After trading publicly for a month and gaining nearly 50% in the process, BJ's Wholesale Club (BJ 1.15%) is the latest consumer and retail IPO for investors to consider.

In this episode of Industry Focus: Consumer Goods, Vincent Shen and Motley Fool senior contributor Asit Sharma go over the major pros and cons of a position in BJ's. The team also introduces a small-cap stock specializing in avocados: Calavo Growers (CVGW -2.60%).

A full transcript follows the video.

This video was recorded on July 24, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen. It's Tuesday, July 24th. For this episode, we'll be turning our attention to two companies that are completely new to the show.

Joining me today via Skype to discuss them is senior Motley Fool contributor, Asit Sharma. Hey, Asit! Great to have you with us!

Asit Sharma: Hey, Vince! Thanks! Great to be here, as always! Hello, listeners!

Shen: Have you been able to stay dry recently? The rain has been constant here. I was looking at the ten-day forecast around Fool HQ, and there are storms expected for pretty much every single day of the ten-day forecast. What's it like down in Raleigh?

Sharma: In Raleigh, it's overcast. It looks like a pool party our swim team was supposed to have is going to get rained out. I will say, I just dropped off two of my kids at camp just outside of Philadelphia, and we were literally running from those storms on the way back. This was Sunday. I had my foot on the gas and dark clouds behind me, but we outran that storm.

Shen: Nice! My wife was actually driving back from that area, too, on Sunday, and she unfortunately got caught in the weather. She said there were parts where everyone on the highway had emergency blinkers on, going 10 miles an hour. It was pretty bad.

Let's kick off our discussion. We're going to take a brief look first at Calavo Growers, ticker CVGW. This is a $1.7 billion market cap company that started off as a farming co-op, converted to a corporation, has been operating as one since 2001.

Calavo's primary business and claim to fame is as a distributor of avocados, though it also deals with other fresh products like tomatoes and papayas. It's also branched out into some newer businesses like fresh packaged foods, which is pretty important.

Asit, this is a small-cap stock. It's not exactly one I expect to make the front page of The Wall Street Journal very often. I'm curious, how did this company end up on your radar?

Sharma: We had an episode on screening for stocks last year. I was looking for small-cap consumer goods companies. I think I set a target revenue growth rate, and that's how this company popped up on my screen. You say "Calavo", I say "Calavo", I'm not sure how it's pronounced. 

I was interested because Calavo Growers is in a very expanding market, the global market for avocados. It's such a nutrient-dense, rich food with many health benefits. The market is growing around a 6% annual growth rate per year. It's about a $13 billion market. So, I thought this might be an interesting niche company to follow, and I started writing about it. I've since been checking on earnings every quarter. 

It has pretty decent earnings. The company nets about 4% on its profit margin. It has about $1.1 billion in trailing 12-month revenues. It's a smaller company. The market capitalization is roughly $1.6 billion. I like these little out-of-the-way companies that dominate a market. 

The last thing I'll say about Calavo before flipping it back to you is, this company based in California gets its avocados primarily from [...] growers, as you mentioned, in California. Also imports from Mexico. The latest stats I have for the California crop, these are from 2016, this company had nearly 30% share of the entire California crop. It dominates in its niche. Fascinating, small [...].

Shen: This discussion is definitely similar to the conversation that we had about Funko not too long ago. It's cool with this business, the company separates their overall business into three operating segments. They have Fresh Products, Calavo Foods, and Renaissance Food Group. The last one was an acquisition from 2011. Fresh Products and Renaissance make up over 90% of Calavo's annual revenue, which cleared that $1 billion milestone you mentioned for the first time in fiscal 2017. 

I think Renaissance in particular has become a highlight for shareholders, given its long growth streak. It had 25 quarters of double-digit growth year over year through fiscal 2017. That has helped the segment to grow. Now, it contributes over 40% of the top line. 

Another important role Renaissance plays is to stabilize the company's results. Avocado consumption has definitely been trending upwards pretty consistently for years at this point. U.S. avocado consumption hit 7.1 pounds per person in 2017. Supply and pricing, as you can imagine, are very much affected by the annual crop and the different regions it gets its crop from -- California, Mexico, also some places like Peru. Things like seasonality and input supply come up a lot for the companies that we discuss, but for a company that has over half of its business directly tied to fresh produce, this seems like one of the biggest risk factors for investors to consider. In their results, they've talked about how wildfires, droughts, and some of these things can affect the pricing and the supply that they have for what is a very strong growing demand for this staple product of theirs.

Sharma: If you decide to follow this stock, listeners, or perhaps invest in it, you should know that the avocado crop is an on-year, off-year crop. One year, low growth, then a bumper crop the next year. We're on an on year in 2018. Industry experts were looking at a very large volume of avocados. Just recently -- this goes back to some of the risk factors perhaps tied to global warming -- they had record heat out in California, 115 degrees in avocado-growing regions. That's taken a little bit of edge off of what would have been a very productive year. 

The last thing I want to say about Calavo is, it has this 43% interest, which Vince talked about, in a company called FreshRealm LLC. It's a very tiny company which makes fresh foods and meal kits. They struck a deal with Weight Watchers International. Vince introduced listeners to Weight Watchers late last year, and we've also talked about on this show what a great run that's had with the Oprah endorsement. Calavo, through FreshRealm, has struck a deal with Kroger Company. So, their meal kits will soon be in Kroger stores. 

The volume of revenue from this subsidiary is really tiny. It's a small company to begin with. This revenue that they received from their subsidiary grew tenfold in the last quarter. Their interest with 106,000. That sounds like peanuts for a publicly traded company, and it is. However, the long-term potential in the meal kit business for a small player that's not trying to take over the market like a HelloFresh or Blue Apron might, there's potential there, unchallenged potential, in some cases. 

This small company has signed some deals with other retailers, which will be disclosed in the back half of the year. We don't know which names they are yet. But, I'm intrigued by the small ownership stake in FreshRealm.

Shen: The last thing I'll end on is, I was looking at your coverage of this company on Fool.com. You have referred to Calavo as a small but mighty dividend payer. The company offers shareholders a single annual dividend payment based on the latest $0.95 per share distribution. The stock yields about 1%. The company's dividend history is not super well-established, but there's no denying that the total returns vs. the broad market have been unbelievable. That's whether you look at the past year or if you go back five, ten years. Definitely an outperformer here. 

At the same time, the stock does have a bit of a premium valuation. It currently trades at about 33x forward earnings. But even with that higher valuation, the higher price point, I think you have to appreciate the story here, given the growing popularity of avocados worldwide. Even in the company's main market, in the U.S., Calavo mentions demographic changes that offer a major tailwind -- the U.S. Hispanic population is set to double in the next three decades. And, regions like Mexico are already known to consume far more avocados on a per-capita basis, so, the run up from that. 

Also, you have a business that benefits significantly from scale. Calavo, as we've talked about, with that 30% share of the California crop back in 2016, it's one of the biggest avocado distributors among the 100 or so competitors in the market. The company mentions that a good portion of its cost structure beyond the fruit itself is fixed. The higher the volumes, the lower the cost per pound of product. That scale can be really helpful here. 

An interesting smaller-cap company that we like to introduce every couple of episodes. Next up, we'll move on to our main topic, which is a recent retail IPO to consider.

We've received a few requests recently to talk about BJ's Wholesale Club. They priced their IPO in late June, last month, at $17 under the ticker BJ. Shares are up about 50% from that level in approximately one month of trading. The chain has actually been around since the 1980s, but BJ's was taken private in 2011 by private equity investors for about $2.8 billion. Those shareholders still own about 70% of the company. 

BJ's locations are concentrated on the East Coast. They have 215 stores, 134 gas stations, and about $13 billion of revenue in the trailing 12-month period. That puts its business at about one-tenth the size of industry leader and closest peer, Costco (COST 0.17%). That matchup was actually the main point of interest from listeners who wanted to know, how do these two companies compare?

Before we get into that, I figure it's helpful to lay some groundwork by hitting the strengths and weaknesses in this retail story. Asit, if you're selling more of the bull thesis for the company, some of the pros, what are the things that jump out to you?

Sharma: Reading through the company's prospectus just before it went public, I was surprised by a number of things. As they'd been private for many years, as you mentioned, BJ's has 3X the number of clubs that Costco does in its core Northeast market. BJ's basically started in the Northeast. That's a lucrative market. The company says that there's disproportionate amount of U.S. GDP concentrated in the Northeast, and that's true to some extent, although we do have some in metropolitan areas. I could make an argument that California also has a great share of U.S. GDP. We'll return to California later in this discussion. 

I was impressed that the company has $2 billion worth of annual sales from its two private label brands, Berkley Jensen and Wellsley Farms. BJ's used to have 13 private label brands. It cut these labels down to two and became more efficient with them. It's a well-run business, in the aspect of understanding how this relationship between open goods and private goods functions, and how to maximize that opportunity.

I did want to bring up something for later discussion. The company had about half of its adjusted EBITDA -- earnings before interest, taxes, depreciation and amortization -- from its membership fees. Remember that statistic. When we talk about Costco, we'll return to this. 

I like that it has a positioning that's between the warehouse and the grocery store. It has 7,200 stock keeping units, or SKUs, on average. That compares to an industry average of 4,500 SKUs. While you won't see quite the amount of bulk products in a BJ's as you will in a Costco, there are many sections that are more like a traditional grocery store. The company touts that as an advantage. I think it's an advantage, but there's some vulnerability in there as well, because they're straddling two different concepts.

The company also has a warehouse industry-leading average of visits by members. On average, members visit about 22 times a year -- basically twice a month. That's a pretty high frequency for a club membership. More typical is once a month or once every six weeks. There's a distinct advantage there related to its high loyalty. Membership renewal for customers who have been with BJ's for two to three years was around 86% in 2017, and that was an all-time high. 

I want to put in one more advantage that the company has, and that is a focus on reasonably well-off households who have an income of $75,000 or above. In a two-earner household, that's not an upper-class income, but it's a very high base level vs. a grocery store's target, which could be $20,000-25,000 below that; or a club target, which would be in the $50,000 range. Dollar stores go below there.

Many nice things popped out from reading this. I think if you're looking at BJ's as a long-term holding, you're interested in the fact that it's situated on the East Coast, it's small in comparison to Costco, it's not straddling the whole United States with a bunch of distribution centers. Small, nimble, with a good handle on running its business.

Shen: I'll add to that. A few things you mentioned, the private label brand is definitely an interesting one, how they've consolidated from that 13 to the two. They've mentioned that those private label brands have doubled their share of merchandise sales in the past five years. So, they've seen a lot of progress there. As we've talked about previously with private labels, they tend to help increase customer loyalty, help with profitability, as well, in terms of the better margins. 

Some of the other momentum that I'll close out with for this part of the discussion, in terms of the BJ's Wholesale Club business, is with the comparable sales, they're seeing an uptick there, 2% excluding gasoline sales for the most recently reported quarter. As a result of some initiatives from the CEO, Chris Baldwin, and other members of leadership at the company, they've managed to do things like negotiate $260 million of savings from their suppliers. Profitability for the company has been improving with expanding gross and adjusted EBITDA margins.

Last one for me in terms of a more long-term outlook, I think the concentrated geographical footprint for BJ's Wholesale Clubs on the East Coast leaves it with an opportunity to expand. In the IPO prospectus, the company says that its distribution centers that it currently has can support an additional 100 locations on the East Coast. They plan to open about 15 to 20 new clubs in the next five years. Keep in mind that its 215-club footprint is still quite small compared to both Costco at around 700 and Sam's Club, which is part of Walmart, which is around 600. So, you can see an opportunity both within the East Coast, its area strength, but also moving out broader if it does want to start to expand into other parts of the U.S.

In terms of the weaker side of the story, some of the cons or more bear sentiment, I think there are also some concerning things to point out in terms of the company's track record. For example, I just mentioned the 2% comparable sales growth last quarter excluding gasoline sales. If you look back further, the company has logged negative comps five years straight. The recent uptick is definitely something that we don't know, in terms of consistency, how well they'll be able to keep that up. It's not nearly as reassuring to potential investors. Was there anything on that side, on this more negative side, that jumped out to you, Asit?

Sharma: Sure. If you look back over the last four or five years, the company's top line has been static, between $12.5-13 billion mark that you mentioned, Vince. Also, in the past, it was heavily indebted. The reason that BJ's went public was, of course, to reward some of the private equity shareholders, but also to pay down some debt. The company has about $1.8 billion of debt. It used almost all of its $600 million of IPO proceeds to become a little less indebted. 

I often talk about debt in relation to EBITDA. The ratio that BJ's has now -- these are really ballpark numbers -- it has about 3X debt to annual EBITDA. Not so bad anymore. You would think, with the interest expense that the company saved from refinancing, which is about $55 million a year, we have a really good net income boost to celebrate. But I want to talk about the company's margins for a second. 

The company in its fiscal year that ended February 3rd, 2018, made about $52 million on $12.5 billion worth of income. That is a profit margin of 0.4% -- less than 1%. In the grocery industry, if you're making 1%, that's great. In the club industry, the warehouse industry, if you're making 2%, that's more of a gold standard. You basically sell billions and billions' worth to grab that 2%. That's what Costco does. 

The thing that BJ's has not been able to do, despite being owned by a private equity group for the last five or six years, is improve its operations enough to scale that 1-2% range. This refinancing will help, and certain cost initiatives that Chris Baldwin, the CEO, has initiated in procurement will help. Last year, they were able to get an additional $260 million on savings on an annual basis from procurement initiatives. But the company, straddling these two categories, I think you'll find it very hard to get to where Costco is -- that 2% net profit. That is a little bit of risk. It makes it vulnerable to Costco moving eastward. 

I mentioned California. Costco has a concentration, first, in North America. About 87% of its revenue comes from the U.S. and Canada. But 30% of Costco's net revenue comes from California. Near-term strength, long-term vulnerability. What's smart for Costco is to gradually move eastward. Of course, it's on the East Coast, but that's the second big dense area for Costco over time to be extremely competitive, and to reduce its reliance on California. 

If you read Costco's annual report, you'll see that's usually the first risk the company lists in its long list of risks that affects its operations -- that it has these concentrations in North America and California. At some point, we may see fiercer competition on the East Coast. I worry about BJ's margins and ability to respond to more aggressive encroachment by Costco.

Shen: Yeah, especially as thin as those margins are. These next points that I'll make definitely delve more into that direct comparison with Costco that our listeners wanted to see. 

Another regular contributor to both Industry Focus and Fool.com, Adam Levine-Weinberg, he wrote a piece soon after the BJ's IPO, laying out his bearish view of the company. He mentioned some pretty sobering points. Something that really jumped out to me, was very eye-opening, he talks about productivity of Costco vs. BJ's locations. Estimates for sales per square foot come in at about $540 for BJ's, but $1,245 for Costco. That helps explain why, even though Costco has about 3.5X the store base of BJ's, it has closer to 10X the revenue. In terms of efficiency and productivity, you can definitely see the difference between these two companies. 

Even on a membership basis, Costco locations have about 3X as many members as BJ's clubs, and Costco's customers tend to be even higher income. I think we said that BJ's targets the $75,000 annual income demographic. Costco's customers, closer to $100,000. They tend to spend more. 

Even on renewal rates, 86%, pretty strong for BJ's. Renewal rates for Costco are about 4% higher at over 90%. Again, a look into the differences between these two companies, and how Costco, even at its larger scale and size, is able to eke out some stronger points there.

Final thoughts on this comparison. You also have to consider things like the valuation. BJ's shares are trading at about 22X forward earnings. Costco is at a pretty good premium to that at 32X earnings. Something that I look at here, just sales from Costco's Kirkland Signature private label came out to $35 billion in 2017. That's nearly 3X companywide revenue for BJ's.

We mentioned this with Calavo, this is also a space where that scale is really important, when you're working in these razor-thin margins. Having that additional buying power, that negotiating power with suppliers, and having such a strong private label business -- in this case, for Costco -- I definitely think has its advantages.

I'm curious, anything jump out to you for this comparison. Also, what are your thoughts, in terms of somebody who wants to invest in the wholesale club retail niche? Do you have any strong thoughts, in terms of, both companies, one or the other? Where do you stand here, Asit?

Sharma: Let me tackle your first question first, Vince. This idea of square footage productivity is fascinating to me. BJ's is focusing now on an 85,000 square foot concept. For a long time, experts in the industry associated with higher productivity per square foot with smaller stores. Companies like Costco and Whole Foods have turned that notion on its head. Costco's average warehouse size, as investors would know, is about 145,000 square feet. 

This is the flip side of the economics that BJ's touts as an advantage -- that it's part grocery store, part wholesale club. If you have an edifice which is almost 150,000 square feet, you have the room to put appliances in, to put garden in, to put a pharmacy in. These are all higher-ticket items and revenue drivers, vs. trying to sell boxes of cereal, not in bulk but as cereal that you'd find in a grocery stores in individual boxes. The disadvantage of having an 85,000 square foot store is, you lose out on those big-ticket items which generate those higher dollars per square foot, and then flow through to the bottom line. 

Costco, as I mentioned, has that 2% margin. Those who follow Costco like to look at, what's the revenue for its membership fees? You look at that number, it's almost always very close to what it makes in net profit each year. Everything else is just in and out. That's a formula which Costco has shown they can do at great scale with very large stores. 

What I am worried about, too, with BJ's dependence on a quasi-grocery store within its stores is, it's more susceptible than Costco to retail disruption. We're seeing the channels in which people buy their goods change almost overnight in the last ... it's really two years, but it feels like it's overnight, as more commerce shifts to delivery via Instacart, ordering online. I think Costco, with its very strong balance sheet, has more of a means to invest in the technology to compete with e-commerce and the changing ways that consumers purchase.

The last thought, do you buy both of these, do you favor one over the other, I think Costco is still the gold standard as far as warehouse clubs are concerned. BJ's has to show us some operational improvement. We often talk about IPOs, we tell investors on this show, wait a couple of quarters, maybe then take a position, unless it's a really great concept. I would say wait one to two years. I think we need one or two years of data to see how BJ's, under its relatively new leadership, can work this equation of now being a publicly traded company, accessing more expansion in Florida and the Mid-Atlantic, outside of its home base of the Northeast. 

I would wait before investing. It's had a good run since its IPO, but it's only been a few weeks. Not a bad business, but not a compelling reason, in these financials, for the narrative, to invest today, from my perspective. What about you, Vince? What are your thoughts?

Shen: I think I'm on the same page. The rule of thumb that we establish with IPOs, in terms of giving them at least a few quarters to value the results as a public company, is really important here. We've seen comparable sales growth at 2% in the latest quarter. How consistent can that be? How well will they be able to keep that up? I'm definitely going to be watching that. 

Seeing how well they catch up, in terms of the more efficient operations of their larger competitor, or whether that profitability catches up, the productivity of its stores, once they've established, potentially, this stronger track record of growth, I can definitely see a better story there for an investor. Otherwise, if you're really looking into this space, as you described, Costco is definitely the gold standard. Those are my final thoughts. Anything else from you, Asit?

Sharma: The last thought that I have for both of these companies -- the industry surprised me when I was doing some research for the show. It's still growing, by some sources, at a compounded annual growth rate of 4-6%. I thought, with all the changes coming, especially from the encroachment of companies like Aldi and the German grocer Lidl, the expansion of Wegmans, and the grocery wars that affect that grocery component, that the warehouse segment might have a cloud over it. 

Listeners, I found out that it's still a persuasive segment to invest in. At the end of the day, people love to have the membership and the savings that they can rely on through the year. Still not a bad place to invest. If you're curious with everything we see with grocery stores and what's happening to those financials, is that spilling over into this area? Just a little bit, but really not in a significant way.

Shen: Thank you so much for joining us today, Asit!

Sharma: Thanks, it was a pleasure!

Shen: Thank you Fools for listening! People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!