Can BJ's Wholesale Overcome These Major Headwinds?

Industry Focus is breaking down the strengths and weaknesses of BJ's Wholesale Club (BJ 0.35%) following its return to the public markets in June.

In this video, the team dives into the company's risks and the pillars of a bear case for the stock.

A full transcript follows the video.

This video was recorded on July 24, 2018.

Vincent Shen: 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?

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 (COST 1.01%) 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.