Industry: Energy and Utilities
April 9, 2010
Investment Recommendation: Overweight
Henry Fund Research
Consumer Staples- Retail (Warehouses) Eric Gorres [email protected]
INVESTMENT THESIS (+) The SPDR Series Trust Retail ETF is up over 50% from its November 2008 low. In 2009, as the S&P 500 Index rose 22%, the Retail Sector ETF rose over 60%. Consumer staples are countercyclical and thus hold up quite well during a recession, but fall when entering a recovery.
SPDR S&P Retail ETF (XRT) Price
480.25 480.49 303.81 1.15% 16.32 2.54
52 Week High 52-Week Low Dividend Yield P/E Ratio P/B Ratio
Major Players by Market Cap (Billions) Wal-Mart (Sam’s Club) Costco Meijer, Inc BJ’s Wholesale Club
204 26 14.6 1.9
Market Share 2010 4%
2% 3% Wal- Mart Costco
19%
Meijer BJ’s Wholesale
72%
(+) China’s ability to provide low cost labor has given the country a significant advantage in global manufacturing. However, as China enjoys an increasing minimum wage and growing quality of life, this low cost advantage will disappear. Warehouses will have to look elsewhere to maintain their low supply costs. Conversely, wholesalers could stand to gain from the emerging middle class of Brazil, Russia, India and China (BRIC countries) as they look for new markets to enter. (-) The US Dollar strengthening poses another challenge to the industry. A rising dollar means reduced revenues from foreign operations. According to the International Trade Commission, Canada and Mexico provide the primary demand for domestic appliances and apparel. We predict the dollar will continue to rise against other currencies. (+) The current recession has had quite an impact on consumers psyche. They are repairing their balance sheets and mindful of the tough economic times. We believe they will continue to be price sensitive. As such, we believe the warehouse industry will continue to do well. We believe Sam’s Club, due to its connection with Wal-Mart, is the best-positioned firm. Sam’s Club enjoys advantages in distribution, inventory and operations management, product selection, and sales margins. These advantages allow Sam’s Club to offer better selections at lower prices for their customers.
Other
Important disclosures appear on the last page of this report.
THE UNIVERSITY OF IOWA
Henry Fund Research
Henry B. Tippie School of Management
EXECUTIVE SUMMARY
Negotiating Leverage
It has not been a pleasant ride, but the S&P 500 is up 1 almost 80% since its March 2009 low of 677. The recent expansion in the economy appears fragile, and a “double dip” recession is possible. The outlook for the broader economy is very unclear.
The market size and strength of the companies gives the big four companies a formidable advantage over their suppliers. This negotiating power helps the warehouses demand and receive lower prices and the warehouses are then able to reduce prices for their customers.
Consumers are still tightening their wallets, scrutinizing their expenditures closely, and fixing their personal balance sheets. Warehouse shoppers continue to curb spending on fashion apparel and accessories, fine jewelry, and home furnishing. Staples items, such as food and toiletries, continue to be big sellers.
Sam’s Club, through its relationship with Wal-Mart, is traditionally the leader is this category. They simply have more influence than their competitors do. However, Costco, Meijer, and BJ’s Wholesale all enjoy distinct bargaining advantages over mom and pop retailers, just not on the same scale of Sam’s Club.
We believe the warehouse industry will provide an attractive investment opportunity, and the sector should Average Size be overweight. Customers enjoy cost savings on bulk Average Store Size 2010 purchases, demand a one stop shopping experience, and will continue to carefully spend their money at warehouse centers. 200,000 We believe the unemployment rate will remain 150,000 stubbornly high for an extended time and the broader 100,000 economy will not show marked improvement in 2010. 50,000 Our current consensus is for the unemployment rate to be 9.68% in six months, and 8.51% in two years. This scenario does not paint a pretty picture for the consumer. Thus, we recommend an overweight rating for the sector.
INDUSTRY DESCRIPTION
Source: Yahoo! Finance and Hoovers
The physical size of the warehouses is another important factor. Current expectations are that the four major players will continue to increase the size of their buildings. Consumers want larger store sizes because they lead to a broader array of products and services available under one roof.
The US Warehouse industries products include: apparel, domestics, fabrics, stationary, books, shoes, house wares, hardware, electronics, home furnishings, small appliances, automotive accessories, office supplies, horticulture accessories, sporting goods, toys, pet food and accessories, cameras, health and beauty aids, pharmaceutical, and jewelry. The stores also offer an assortment of grocery merchandise. Most importantly, the stores merchandise includes bulk displays of goods.
Customers also want this in order to limit the amount of stops they must make when doing their shopping. This helps families save on gas money. Families, particularly families with small children, enjoy making The US Warehouse industry is highly concentrated, one stop to purchase all the families goods. with four major players accounting for 90% of market The increase in the average store size helps the share. Of these, Wal-Mart Sam’s Club) is the biggest, company in other ways as well. With increased shelf with 72% of market share. Meijer Inc is a privately held space and economies of scale comes increased company. The high level of concentration and bargaining power, and the warehouses will be able to considerable capital required to create enough revenue use it to further reduce prices for their customers. to compete with the big four ensures that new entrants Suppliers will go along to ensure their product reaches to this field are unlikely. the amount of customers these warehouses serve. The Warehouse industry is distinct in that most products carry a very low profit margin. Thus, they are dependent on both customer loyalty and increased customer traffic. The relationship with their customers, the customer service they provide, and the price they can deliver is of utmost importance.
2
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Henry Fund Research
Henry B. Tippie School of Management
Cost Structure
RECENT DEVELOPMENTS
The cost structure of the industry continues to be favorable. The single largest expense is the purchasing of the goods. Warehouses are constantly sourcing products from new, low cost producers. Any dollar amount that warehouses can keep from going to their suppliers will go straight to the warehouses bottom line.
In 2005, Wal-Mart commissioned a study to determine the effects its utilization of Radio Frequency Identification (RFID) technology had on the company’s operations. The results were startling: a 16% reduction in out of stock goods, a threefold improvement in the speed of replenishment of out of stock items with electronic product codes (EPCc) vs. non tagged items, a 63% improvement in replenishing tagged items versus control stores and a 10% reduction in manual 5 orders, which reduced excess inventory. The information the RFID’s could potentially provide was hailed as a market moving technology. The cost savings the operators could wring out of the system was going to be magnanimous.
Additionally, those warehouses that make investments in inventory and operations management systems enjoy more favorable cost structure. In this area, Sam’s Club is the clear leader. Sam’s Club benefits from WalMart’s massive investments in these systems. They also enjoy Wal-Mart’s expertise in optimizing company use of these systems. The combination of investment and expertise allow Sam’s Club to enjoy margin advantages over their customers. Fast forward five years, and the results have not exactly lived up to the hype. RFID use has not caught on Cost Structure industry wide. Thomas Gruen and Daniel Corsten from the University of Colorado did a study in 2007 showing Purchases Wages Depreciation that 70-75% of items that are out of stock are the result of labor efforts and store processes, not operations Rent Advertising Other 9 management or supplier delivery practices. Wal-Mart Profit has not given up on the technology though, and still requires RFID’s on all pallets that enter a Sam’s Club. 5% 5% In early 2009 Sam’s Club lowered the penalty for failure 1% 1% to tag pallets from $2-$3 a pallet to $0.12 cents a pallet. 1% 7%
INDUSTRY TRENDS 80%
Source: IBIS World
The introduction of private label products has given the warehouses (and all retailers) an increased revenue stream and unique bargaining chip. These goods offer the same product at a similar quality but a lower price, which results in a higher margin for the warehouses.
Warehouses generally inventory their goods in racks above the sales floor, which reduces the needs for expensive labor. Wal-Mart’s recent announcement that the company is increasing its minimum wage may lead other industry players to follow suit.
Private label brands have become very sophisticated and widely accepted. In some cases (Costco’s Kirkland Signature), they outsell their national brand equivalent. Warehouses continue to expand the product range their private label brands offer.
The industry needs to be keenly aware of any efforts to organize by employees. If the organizing efforts are successful, the cost structures will significantly increase for all companies involved.
Warehouses will use the higher margin of the private labels as a bargaining chip to demand further price cuts from major suppliers in order for the national brands to compete for limited shelf space. The warehouses will then pass these price savings onto their customers.
There is an industry identified need to employ friendly and helpful staff. These courteous and knowledgeable workers will help generate customer loyalty and repeat sales. As no companies in this industry enjoy high margins, repeat buyers make or break a company’s success.
Private label goods have been widely accepted and will be a force after the recession as well. According to a June 2009 national study, 91% of shoppers will stick 6 with private label brands after the recession is over. For further certification that customers are increasingly turning to private label brands, in 2009 private label unit share grew to 22.8% of all retail sales with share 10 growing in grocery, drug, and dollar stores.
3
THE UNIVERSITY OF IOWA
Henry Fund Research
Henry B. Tippie School of Management
MARKETS AND COMPETITION
Operating Margin 2010
Price, choice, and convenience are the main factors of competition within the Warehouse industry. Industry analysts, however, warn customers to not enter a warehouse without doing their homework. This is because while warehouse chains maintain they carry the lowest prices, they often mark up their prices to be in line with local competition.
25 20 15 10 5 0
Sam's Club Costco BJ’s Wholesale
Inventory turnover is very important in the warehouse industry. A warehouse sells products that have very low margins. They want that product to sell quickly and the customer to come in and purchase more. Warehouses do not want products that stay in inventory for a long time. Source: Yahoo! Finance
Operating margins are an important barometer in the retail industry. They are indicative of how well a company runs its operations and the value proposition it is trying to send to the customer.
Inventory Turnover 2010 14 12 10 8 6 4 2 0
According to our analysis, Sam’s Club enjoys the largest operating margin of the competitors. We believe they enjoy considerable advantages from Wal-Mart that the other companies simply cannot replicate. We also look for Sam’s Club to extend this leadership position due to Wal-Mart’s continued investment in inventory and operations management systems.
Sam's Club Costco BJ’s Wholesale
Return on Capital 2010 15 10 5 0
Source: Yahoo! Finance
Note: Limited information was available on Meijer for the following analyses, as it is a privately held company.
Sam's Club Costco BJ’s Wholesale
From the chart above, Costco is the most efficient at turning over its inventory. This was likely due to the widespread popularity of the Kirkland Signature. Given the mature nature of the industry and that the Source: MSN Money main base of competition is price, industry experts have recognized that increased profit gains will come from Return on capital is exactly what it sounds like: a measure of how well a company used its capital (debt the supply of goods, not the demand. and equity) to generate a return. With inventory turnover relatively high, look for further expansion and investment in RFID, advanced Again, Sam’s Club is the leader of the main competitors operations management techniques, and continued in the industry. The return numbers are very close among the competitors. This is not surprising as all employee training. three of these companies employ very shrewd management teams and operate in the same environment.
4
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Henry Fund Research
Henry B. Tippie School of Management
ECONOMIC OUTLOOK
Price/Sales 2010 0.5 0.4 0.3 0.2 0.1 0
The unemployment rate was at 10% at the end of 2009 2 before improving to 9.7% in January 2010. In times of sustained high unemployment, warehouses have traditionally performed well as people have a tendency to trade down to lower priced goods.
Sam's Club
Our current consensus is for the unemployment rate to be 9.68% in six months, and 8.51% in two years. We believe retailers will continue to see rising revenues going forward as consumers will still be watching their wallets.
Costco BJ’s Wholesale
If unemployment should begin to improve, consumers will soon begin to purchase higher margin and products that are more expensive. The risk with improving Source: Yahoo! Finance unemployment for warehouse clubs is that their The price to sales ratio measures how much investors customers will trade up. We expect improving are willing pay for every dollar of a company’s sales. unemployment figures to result in lower revenue figures BJ’s Wholesale has a much lower price/sales ratio than for all companies in the industry. the competition, and a lower price/sales ratio is Real GDP grew 5.9% in the fourth quarter of 2009, after generally better. We look for the companies to move increasing 2.2% in the third quarter. Most of the growth closer as the economy improves. was due to a slowdown in the rate at which businesses drew down their inventories. As such, the growth in GDP has not translated into positive moves in other Warehouses encourage customer allegiance through areas of the economy. We believe that GDP growth will membership fees and loyalty cards. Customers receive moderate to 2.1% in the next six months, and 2.8% in incentives to purchase bulk and case quantities that two years. provide savings for the customer and increased efficiency within the distribution system. Clean stores, convenient locations, parking, and an efficient in-store layout encourage repeat shoppers. Member Loyalty
New Store Openings New store openings continue to appear across the industry, but at a subdued pace from years prior. New Store Openings
2010
Costco
16-48
Sam’s Club
15-20
Source: company filings
The Producer Price Index rose 0.2% in December, to 3 finish at 4.4% for all of 2009. Traditionally suppliers have sent these costs to the consumers. We do not expect inflation to be a problem for the near future, predicting 1% inflation in six months, and 2.50% inflation in two years.
New locations tend to track population growth, with the exclusion of BJ’s Wholesale, which is located primarily in the East Coast, and Meijer stores, which are primarily in Michigan, Ohio, Indiana, Illinois, and Kentucky. Costco tends to have fewer stores and they tend to be in more affluent locations than their competitors are. Sam’s Clubs are located all across the country. BJ’s Wholesale did not have estimates for new store openings at the time of writing. Competition for new locations is fierce and the price for prime real estate is typically very expensive.
Also worth noting is the recent fall in consumer confidence. It is now at 46, down from 56.5 in January. The decline in consumer confidence can be attributed to pessimism about job prospects and income worries. While some indicators, such as The Conference Board Leading Economic Index, are showing the recession is
5
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Henry Fund Research
Henry B. Tippie School of Management 4
INVESTMENT POSITIVES
over, consumers are still feeling the pain. An index level of 100 is normal, so the index has a long way to go to get to a normal state. Consumers will be carefully watching their purchases for the near future.
Warehouses continue to strengthen their online presence. Consumers can order a product online and then pick it up at a local store or have it delivered to their home. Sam’s Club, BJ’s Wholesale, and Costco are now offering members specials and products they cannot purchase at the warehouses. This additional sales avenue provides more convenience and lower prices to customers. In addition, Meijer has unveiled Grocery Express, which allows customer to shop online and have the groceries delivered to their car.
Consumer staples are not as sensitive as other industries during a recession. Warehouses in particular stock many consumer staples and have been a safe place to park investment dollars in the past few years.
Due to the growing size of the warehouses and variety of products they offer, customer sensitivity to gas prices, and tough economic conditions, customers are making fewer trips per month, but are spending more each time they enter the store.
The demand for low priced goods will continue as long as the economy fails to gain traction and consumers are concerned about the broader economy.
Look for February sales numbers to be up YOY as the Super Bowl was in February instead of January.
The two largest industry players continue to expand internationally. Costco now has operations in Canada, UK, Korea, Taiwan, and Japan. Sam’s Club has operations in Puerto Rico, Mexico, Canada, Brazil, and China. Costco and Wal-Mart hope to capitalize on the emerging wealth of these new markets. Furthermore, no international competitor has arrived in the US. This is most likely due the market saturation in the US.
Source: The Conference Board
The Fed’s decision to raise interest rates will have very important ramifications for the broader economy. Rate increase will reduce further increases in the equity markets. The cost of capital will also undoubtedly increase, making further expansion or new initiatives prohibitively expensive. Current Henry Fund projections place the Fed Funds rate at roughly the current (0.25%) rate in six months, and almost 2% in two years.
CATALYSTS FOR GROWTH Changing demographic trends will provide a boost to sales revenues going forward. Generation’s X and Y in particular are just beginning to enter their prime earning years of their careers, and they have just a 42% and a 52% penetration rate. The Household Penetration rate refers to the percentage of households who have shopped at a warehouse club at least once. As Generation X and Y income’s and the size of their families increase, the number of trips per year and the average dollars spent per trip will increase as well. Demographic
Trips/Year
Ave. Spent
Household Penetration
Gen Y
8
$78
42%
Gen X
10
$94
52%
Baby Boomers
11
$91
51%
Pre-Boomers
11
$75
INVESTMENT NEGATIVES
The warehouse industry is notorious for demanding price cuts from suppliers. The suppliers typically go along in order to have their goods reach the masses, but at some point their margins will becomes so small they will pull out of the warehouses altogether.
Although industry concentration is high, price continues to be the main point on which industry players compete. In a downward spiral to the lowest price on everything, prices could get cut to the point of unprofitability.
The Warehouse industry faces brutal competition from grocery stores, retail stores, and discount
49%
Source: ACNielsen
6
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Henry Fund Research
Henry B. Tippie School of Management
stores. If industry players cannot continue to beat purchases from department stores. If the economy other players on price, customers will take their rebounds in 2010, we expect consumer to begin to dollars elsewhere. trade up and for discount retailers to see lower revenue figures. If the overall economy, unemployment levels, New stores have very large physical size and capital and consumer confidence begin to improve, there will requirements. Due to this, new locations are placed be other sectors that will provide a higher return than in high population areas to generate the required warehouses and consumer staples. rate of return. Looking forward, new warehouse locations will be much more expensive and difficult to obtain. Cannibalism could also become a problem if an overcapacity of stores is built. REFERENCES 1. finance.yahoo.com
VALUATION
2. http://www.bls.gov/
The outlook for this sector is heavily dependent on the 3. http://www.bls.gov/news.release/pdf/ppi.pdf economic future and customers expectations. Industry 4.http://www.conference5 revenue growth is projected to grow 4.3% , but growth board.org/economics/consumerconfidence.cfm rate is subject to overall economic conditions. 5. IBIS World Industry Report We do not believe the economic recovery will be neither quick nor robust. Customers are likely to continue to be 6.http://plma.com/share/press/FOR_IMMEDIATE_REL mindful of their spending, and warehouse clubs will EASE/PLMA_Store_Brands_and_the_Recession2.pdf continue to see the benefits of this thriftiness. In addition, warehouse clubs are expanding their stores, 7. JPMorgan- Costco Wholesale Corporation offering more products and services to customers to “What Happens in Vegas….Meeting Highlights, increase the value proposition. Finally, the acceptance of private label goods among customers allows the Stay Overweight.” Research note to clients warehouses to capture a larger margin on name brand 8. Wal-Mart 2009 Annual Report goods. 9. A Comprehensive Guide to Retail Out-of-Stock Sam’s Club, through its relationship with Wal-Mart, is the best-positioned firm going forward. Sam’s Club has Reduction in the Fast Moving Consumer Goods the largest EPS, profit margins, and has a reasonably Industry. http://www.uccs.edu/~tgruen/research.htm low P/E of 13.46. As the recent consumer confidence numbers indicate, consumers believe we are still in a 10.http://supermarketnews.com/images/T_T_Septembe recession. They will likely continue to stretch their sales r_2009_Private_Label.pdf dollars as far as possible and the Warehouse Clubs will continue to be the beneficiary of their purchasing decisions. Wal Mart also has the market size and IMPORTANT DISCLAIMER strength to constantly put pressure on suppliers to This report was created by a student(s) enrolled in the Applied lower costs. Sam’s Club then benefits by passing these Securities Management (Henry Fund) program at the University of cost savings to customers, and gains even more market Iowa’s Tippie School of Management. The intent of these reports is provide potential employers and other interested parties an size and strength. This productivity loop is a significant to example of the analytical skills, investment knowledge, and competitive advantage that the other big three communication abilities of Henry Fund students. Henry Fund companies do not have the ability to imitate right now. analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report.
There are risks to the downside however. Many customers traded down to warehouse clubs to save money during the depths of the recession. All the warehouses need to prove they can retain these customers when the broader economy improves. Furthermore, during periods of strong economic growth and consumer confidence, consumers are not as price sensitive and are likely to upgrade to higher end
7
Investment Recommendation: Overweight
Henry Fund Research
Consumer Staples- Retail (Warehouses) Eric Gorres [email protected]
INVESTMENT THESIS (+) The SPDR Series Trust Retail ETF is up over 50% from its November 2008 low. In 2009, as the S&P 500 Index rose 22%, the Retail Sector ETF rose over 60%. Consumer staples are countercyclical and thus hold up quite well during a recession, but fall when entering a recovery.
SPDR S&P Retail ETF (XRT) Price
480.25 480.49 303.81 1.15% 16.32 2.54
52 Week High 52-Week Low Dividend Yield P/E Ratio P/B Ratio
Major Players by Market Cap (Billions) Wal-Mart (Sam’s Club) Costco Meijer, Inc BJ’s Wholesale Club
204 26 14.6 1.9
Market Share 2010 4%
2% 3% Wal- Mart Costco
19%
Meijer BJ’s Wholesale
72%
(+) China’s ability to provide low cost labor has given the country a significant advantage in global manufacturing. However, as China enjoys an increasing minimum wage and growing quality of life, this low cost advantage will disappear. Warehouses will have to look elsewhere to maintain their low supply costs. Conversely, wholesalers could stand to gain from the emerging middle class of Brazil, Russia, India and China (BRIC countries) as they look for new markets to enter. (-) The US Dollar strengthening poses another challenge to the industry. A rising dollar means reduced revenues from foreign operations. According to the International Trade Commission, Canada and Mexico provide the primary demand for domestic appliances and apparel. We predict the dollar will continue to rise against other currencies. (+) The current recession has had quite an impact on consumers psyche. They are repairing their balance sheets and mindful of the tough economic times. We believe they will continue to be price sensitive. As such, we believe the warehouse industry will continue to do well. We believe Sam’s Club, due to its connection with Wal-Mart, is the best-positioned firm. Sam’s Club enjoys advantages in distribution, inventory and operations management, product selection, and sales margins. These advantages allow Sam’s Club to offer better selections at lower prices for their customers.
Other
Important disclosures appear on the last page of this report.
THE UNIVERSITY OF IOWA
Henry Fund Research
Henry B. Tippie School of Management
EXECUTIVE SUMMARY
Negotiating Leverage
It has not been a pleasant ride, but the S&P 500 is up 1 almost 80% since its March 2009 low of 677. The recent expansion in the economy appears fragile, and a “double dip” recession is possible. The outlook for the broader economy is very unclear.
The market size and strength of the companies gives the big four companies a formidable advantage over their suppliers. This negotiating power helps the warehouses demand and receive lower prices and the warehouses are then able to reduce prices for their customers.
Consumers are still tightening their wallets, scrutinizing their expenditures closely, and fixing their personal balance sheets. Warehouse shoppers continue to curb spending on fashion apparel and accessories, fine jewelry, and home furnishing. Staples items, such as food and toiletries, continue to be big sellers.
Sam’s Club, through its relationship with Wal-Mart, is traditionally the leader is this category. They simply have more influence than their competitors do. However, Costco, Meijer, and BJ’s Wholesale all enjoy distinct bargaining advantages over mom and pop retailers, just not on the same scale of Sam’s Club.
We believe the warehouse industry will provide an attractive investment opportunity, and the sector should Average Size be overweight. Customers enjoy cost savings on bulk Average Store Size 2010 purchases, demand a one stop shopping experience, and will continue to carefully spend their money at warehouse centers. 200,000 We believe the unemployment rate will remain 150,000 stubbornly high for an extended time and the broader 100,000 economy will not show marked improvement in 2010. 50,000 Our current consensus is for the unemployment rate to be 9.68% in six months, and 8.51% in two years. This scenario does not paint a pretty picture for the consumer. Thus, we recommend an overweight rating for the sector.
INDUSTRY DESCRIPTION
Source: Yahoo! Finance and Hoovers
The physical size of the warehouses is another important factor. Current expectations are that the four major players will continue to increase the size of their buildings. Consumers want larger store sizes because they lead to a broader array of products and services available under one roof.
The US Warehouse industries products include: apparel, domestics, fabrics, stationary, books, shoes, house wares, hardware, electronics, home furnishings, small appliances, automotive accessories, office supplies, horticulture accessories, sporting goods, toys, pet food and accessories, cameras, health and beauty aids, pharmaceutical, and jewelry. The stores also offer an assortment of grocery merchandise. Most importantly, the stores merchandise includes bulk displays of goods.
Customers also want this in order to limit the amount of stops they must make when doing their shopping. This helps families save on gas money. Families, particularly families with small children, enjoy making The US Warehouse industry is highly concentrated, one stop to purchase all the families goods. with four major players accounting for 90% of market The increase in the average store size helps the share. Of these, Wal-Mart Sam’s Club) is the biggest, company in other ways as well. With increased shelf with 72% of market share. Meijer Inc is a privately held space and economies of scale comes increased company. The high level of concentration and bargaining power, and the warehouses will be able to considerable capital required to create enough revenue use it to further reduce prices for their customers. to compete with the big four ensures that new entrants Suppliers will go along to ensure their product reaches to this field are unlikely. the amount of customers these warehouses serve. The Warehouse industry is distinct in that most products carry a very low profit margin. Thus, they are dependent on both customer loyalty and increased customer traffic. The relationship with their customers, the customer service they provide, and the price they can deliver is of utmost importance.
2
THE UNIVERSITY OF IOWA
Henry Fund Research
Henry B. Tippie School of Management
Cost Structure
RECENT DEVELOPMENTS
The cost structure of the industry continues to be favorable. The single largest expense is the purchasing of the goods. Warehouses are constantly sourcing products from new, low cost producers. Any dollar amount that warehouses can keep from going to their suppliers will go straight to the warehouses bottom line.
In 2005, Wal-Mart commissioned a study to determine the effects its utilization of Radio Frequency Identification (RFID) technology had on the company’s operations. The results were startling: a 16% reduction in out of stock goods, a threefold improvement in the speed of replenishment of out of stock items with electronic product codes (EPCc) vs. non tagged items, a 63% improvement in replenishing tagged items versus control stores and a 10% reduction in manual 5 orders, which reduced excess inventory. The information the RFID’s could potentially provide was hailed as a market moving technology. The cost savings the operators could wring out of the system was going to be magnanimous.
Additionally, those warehouses that make investments in inventory and operations management systems enjoy more favorable cost structure. In this area, Sam’s Club is the clear leader. Sam’s Club benefits from WalMart’s massive investments in these systems. They also enjoy Wal-Mart’s expertise in optimizing company use of these systems. The combination of investment and expertise allow Sam’s Club to enjoy margin advantages over their customers. Fast forward five years, and the results have not exactly lived up to the hype. RFID use has not caught on Cost Structure industry wide. Thomas Gruen and Daniel Corsten from the University of Colorado did a study in 2007 showing Purchases Wages Depreciation that 70-75% of items that are out of stock are the result of labor efforts and store processes, not operations Rent Advertising Other 9 management or supplier delivery practices. Wal-Mart Profit has not given up on the technology though, and still requires RFID’s on all pallets that enter a Sam’s Club. 5% 5% In early 2009 Sam’s Club lowered the penalty for failure 1% 1% to tag pallets from $2-$3 a pallet to $0.12 cents a pallet. 1% 7%
INDUSTRY TRENDS 80%
Source: IBIS World
The introduction of private label products has given the warehouses (and all retailers) an increased revenue stream and unique bargaining chip. These goods offer the same product at a similar quality but a lower price, which results in a higher margin for the warehouses.
Warehouses generally inventory their goods in racks above the sales floor, which reduces the needs for expensive labor. Wal-Mart’s recent announcement that the company is increasing its minimum wage may lead other industry players to follow suit.
Private label brands have become very sophisticated and widely accepted. In some cases (Costco’s Kirkland Signature), they outsell their national brand equivalent. Warehouses continue to expand the product range their private label brands offer.
The industry needs to be keenly aware of any efforts to organize by employees. If the organizing efforts are successful, the cost structures will significantly increase for all companies involved.
Warehouses will use the higher margin of the private labels as a bargaining chip to demand further price cuts from major suppliers in order for the national brands to compete for limited shelf space. The warehouses will then pass these price savings onto their customers.
There is an industry identified need to employ friendly and helpful staff. These courteous and knowledgeable workers will help generate customer loyalty and repeat sales. As no companies in this industry enjoy high margins, repeat buyers make or break a company’s success.
Private label goods have been widely accepted and will be a force after the recession as well. According to a June 2009 national study, 91% of shoppers will stick 6 with private label brands after the recession is over. For further certification that customers are increasingly turning to private label brands, in 2009 private label unit share grew to 22.8% of all retail sales with share 10 growing in grocery, drug, and dollar stores.
3
THE UNIVERSITY OF IOWA
Henry Fund Research
Henry B. Tippie School of Management
MARKETS AND COMPETITION
Operating Margin 2010
Price, choice, and convenience are the main factors of competition within the Warehouse industry. Industry analysts, however, warn customers to not enter a warehouse without doing their homework. This is because while warehouse chains maintain they carry the lowest prices, they often mark up their prices to be in line with local competition.
25 20 15 10 5 0
Sam's Club Costco BJ’s Wholesale
Inventory turnover is very important in the warehouse industry. A warehouse sells products that have very low margins. They want that product to sell quickly and the customer to come in and purchase more. Warehouses do not want products that stay in inventory for a long time. Source: Yahoo! Finance
Operating margins are an important barometer in the retail industry. They are indicative of how well a company runs its operations and the value proposition it is trying to send to the customer.
Inventory Turnover 2010 14 12 10 8 6 4 2 0
According to our analysis, Sam’s Club enjoys the largest operating margin of the competitors. We believe they enjoy considerable advantages from Wal-Mart that the other companies simply cannot replicate. We also look for Sam’s Club to extend this leadership position due to Wal-Mart’s continued investment in inventory and operations management systems.
Sam's Club Costco BJ’s Wholesale
Return on Capital 2010 15 10 5 0
Source: Yahoo! Finance
Note: Limited information was available on Meijer for the following analyses, as it is a privately held company.
Sam's Club Costco BJ’s Wholesale
From the chart above, Costco is the most efficient at turning over its inventory. This was likely due to the widespread popularity of the Kirkland Signature. Given the mature nature of the industry and that the Source: MSN Money main base of competition is price, industry experts have recognized that increased profit gains will come from Return on capital is exactly what it sounds like: a measure of how well a company used its capital (debt the supply of goods, not the demand. and equity) to generate a return. With inventory turnover relatively high, look for further expansion and investment in RFID, advanced Again, Sam’s Club is the leader of the main competitors operations management techniques, and continued in the industry. The return numbers are very close among the competitors. This is not surprising as all employee training. three of these companies employ very shrewd management teams and operate in the same environment.
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Henry B. Tippie School of Management
ECONOMIC OUTLOOK
Price/Sales 2010 0.5 0.4 0.3 0.2 0.1 0
The unemployment rate was at 10% at the end of 2009 2 before improving to 9.7% in January 2010. In times of sustained high unemployment, warehouses have traditionally performed well as people have a tendency to trade down to lower priced goods.
Sam's Club
Our current consensus is for the unemployment rate to be 9.68% in six months, and 8.51% in two years. We believe retailers will continue to see rising revenues going forward as consumers will still be watching their wallets.
Costco BJ’s Wholesale
If unemployment should begin to improve, consumers will soon begin to purchase higher margin and products that are more expensive. The risk with improving Source: Yahoo! Finance unemployment for warehouse clubs is that their The price to sales ratio measures how much investors customers will trade up. We expect improving are willing pay for every dollar of a company’s sales. unemployment figures to result in lower revenue figures BJ’s Wholesale has a much lower price/sales ratio than for all companies in the industry. the competition, and a lower price/sales ratio is Real GDP grew 5.9% in the fourth quarter of 2009, after generally better. We look for the companies to move increasing 2.2% in the third quarter. Most of the growth closer as the economy improves. was due to a slowdown in the rate at which businesses drew down their inventories. As such, the growth in GDP has not translated into positive moves in other Warehouses encourage customer allegiance through areas of the economy. We believe that GDP growth will membership fees and loyalty cards. Customers receive moderate to 2.1% in the next six months, and 2.8% in incentives to purchase bulk and case quantities that two years. provide savings for the customer and increased efficiency within the distribution system. Clean stores, convenient locations, parking, and an efficient in-store layout encourage repeat shoppers. Member Loyalty
New Store Openings New store openings continue to appear across the industry, but at a subdued pace from years prior. New Store Openings
2010
Costco
16-48
Sam’s Club
15-20
Source: company filings
The Producer Price Index rose 0.2% in December, to 3 finish at 4.4% for all of 2009. Traditionally suppliers have sent these costs to the consumers. We do not expect inflation to be a problem for the near future, predicting 1% inflation in six months, and 2.50% inflation in two years.
New locations tend to track population growth, with the exclusion of BJ’s Wholesale, which is located primarily in the East Coast, and Meijer stores, which are primarily in Michigan, Ohio, Indiana, Illinois, and Kentucky. Costco tends to have fewer stores and they tend to be in more affluent locations than their competitors are. Sam’s Clubs are located all across the country. BJ’s Wholesale did not have estimates for new store openings at the time of writing. Competition for new locations is fierce and the price for prime real estate is typically very expensive.
Also worth noting is the recent fall in consumer confidence. It is now at 46, down from 56.5 in January. The decline in consumer confidence can be attributed to pessimism about job prospects and income worries. While some indicators, such as The Conference Board Leading Economic Index, are showing the recession is
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Henry B. Tippie School of Management 4
INVESTMENT POSITIVES
over, consumers are still feeling the pain. An index level of 100 is normal, so the index has a long way to go to get to a normal state. Consumers will be carefully watching their purchases for the near future.
Warehouses continue to strengthen their online presence. Consumers can order a product online and then pick it up at a local store or have it delivered to their home. Sam’s Club, BJ’s Wholesale, and Costco are now offering members specials and products they cannot purchase at the warehouses. This additional sales avenue provides more convenience and lower prices to customers. In addition, Meijer has unveiled Grocery Express, which allows customer to shop online and have the groceries delivered to their car.
Consumer staples are not as sensitive as other industries during a recession. Warehouses in particular stock many consumer staples and have been a safe place to park investment dollars in the past few years.
Due to the growing size of the warehouses and variety of products they offer, customer sensitivity to gas prices, and tough economic conditions, customers are making fewer trips per month, but are spending more each time they enter the store.
The demand for low priced goods will continue as long as the economy fails to gain traction and consumers are concerned about the broader economy.
Look for February sales numbers to be up YOY as the Super Bowl was in February instead of January.
The two largest industry players continue to expand internationally. Costco now has operations in Canada, UK, Korea, Taiwan, and Japan. Sam’s Club has operations in Puerto Rico, Mexico, Canada, Brazil, and China. Costco and Wal-Mart hope to capitalize on the emerging wealth of these new markets. Furthermore, no international competitor has arrived in the US. This is most likely due the market saturation in the US.
Source: The Conference Board
The Fed’s decision to raise interest rates will have very important ramifications for the broader economy. Rate increase will reduce further increases in the equity markets. The cost of capital will also undoubtedly increase, making further expansion or new initiatives prohibitively expensive. Current Henry Fund projections place the Fed Funds rate at roughly the current (0.25%) rate in six months, and almost 2% in two years.
CATALYSTS FOR GROWTH Changing demographic trends will provide a boost to sales revenues going forward. Generation’s X and Y in particular are just beginning to enter their prime earning years of their careers, and they have just a 42% and a 52% penetration rate. The Household Penetration rate refers to the percentage of households who have shopped at a warehouse club at least once. As Generation X and Y income’s and the size of their families increase, the number of trips per year and the average dollars spent per trip will increase as well. Demographic
Trips/Year
Ave. Spent
Household Penetration
Gen Y
8
$78
42%
Gen X
10
$94
52%
Baby Boomers
11
$91
51%
Pre-Boomers
11
$75
INVESTMENT NEGATIVES
The warehouse industry is notorious for demanding price cuts from suppliers. The suppliers typically go along in order to have their goods reach the masses, but at some point their margins will becomes so small they will pull out of the warehouses altogether.
Although industry concentration is high, price continues to be the main point on which industry players compete. In a downward spiral to the lowest price on everything, prices could get cut to the point of unprofitability.
The Warehouse industry faces brutal competition from grocery stores, retail stores, and discount
49%
Source: ACNielsen
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Henry Fund Research
Henry B. Tippie School of Management
stores. If industry players cannot continue to beat purchases from department stores. If the economy other players on price, customers will take their rebounds in 2010, we expect consumer to begin to dollars elsewhere. trade up and for discount retailers to see lower revenue figures. If the overall economy, unemployment levels, New stores have very large physical size and capital and consumer confidence begin to improve, there will requirements. Due to this, new locations are placed be other sectors that will provide a higher return than in high population areas to generate the required warehouses and consumer staples. rate of return. Looking forward, new warehouse locations will be much more expensive and difficult to obtain. Cannibalism could also become a problem if an overcapacity of stores is built. REFERENCES 1. finance.yahoo.com
VALUATION
2. http://www.bls.gov/
The outlook for this sector is heavily dependent on the 3. http://www.bls.gov/news.release/pdf/ppi.pdf economic future and customers expectations. Industry 4.http://www.conference5 revenue growth is projected to grow 4.3% , but growth board.org/economics/consumerconfidence.cfm rate is subject to overall economic conditions. 5. IBIS World Industry Report We do not believe the economic recovery will be neither quick nor robust. Customers are likely to continue to be 6.http://plma.com/share/press/FOR_IMMEDIATE_REL mindful of their spending, and warehouse clubs will EASE/PLMA_Store_Brands_and_the_Recession2.pdf continue to see the benefits of this thriftiness. In addition, warehouse clubs are expanding their stores, 7. JPMorgan- Costco Wholesale Corporation offering more products and services to customers to “What Happens in Vegas….Meeting Highlights, increase the value proposition. Finally, the acceptance of private label goods among customers allows the Stay Overweight.” Research note to clients warehouses to capture a larger margin on name brand 8. Wal-Mart 2009 Annual Report goods. 9. A Comprehensive Guide to Retail Out-of-Stock Sam’s Club, through its relationship with Wal-Mart, is the best-positioned firm going forward. Sam’s Club has Reduction in the Fast Moving Consumer Goods the largest EPS, profit margins, and has a reasonably Industry. http://www.uccs.edu/~tgruen/research.htm low P/E of 13.46. As the recent consumer confidence numbers indicate, consumers believe we are still in a 10.http://supermarketnews.com/images/T_T_Septembe recession. They will likely continue to stretch their sales r_2009_Private_Label.pdf dollars as far as possible and the Warehouse Clubs will continue to be the beneficiary of their purchasing decisions. Wal Mart also has the market size and IMPORTANT DISCLAIMER strength to constantly put pressure on suppliers to This report was created by a student(s) enrolled in the Applied lower costs. Sam’s Club then benefits by passing these Securities Management (Henry Fund) program at the University of cost savings to customers, and gains even more market Iowa’s Tippie School of Management. The intent of these reports is provide potential employers and other interested parties an size and strength. This productivity loop is a significant to example of the analytical skills, investment knowledge, and competitive advantage that the other big three communication abilities of Henry Fund students. Henry Fund companies do not have the ability to imitate right now. analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report.
There are risks to the downside however. Many customers traded down to warehouse clubs to save money during the depths of the recession. All the warehouses need to prove they can retain these customers when the broader economy improves. Furthermore, during periods of strong economic growth and consumer confidence, consumers are not as price sensitive and are likely to upgrade to higher end
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