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How to Invest in Warehouse Club Stocks

Demitrios Kalogeropoulos, The Motley Fool

Warehouse clubs are popular shopping destinations for hundreds of millions of people around the world. The unbeatable low prices they offer draw customers from all demographics. And the subscription-based business model warehouse clubs follow helps those companies generate consistent profits, which is uncommon in the retailing industry .

This combination of popularity and sustainable earnings has attracted many investors to this retail industry niche as they look to earn market-thumping returns . But not all warehouse clubs are created equal, and there are some important factors to consider before buying your first warehouse club stock. Let's take a comprehensive look at everything you need to know to invest in warehouse club stocks.

A shopper browses through the warehouse aisles.

Image source: Getty Images.

What is a warehouse club?

Quite simply, a warehouse club is a retailer that limits store access to subscribers who pay an annual fee for the right to shop at its locations. But beyond this dues-based selling approach, a number of characteristics of a warehouse club distinguish it from your average retailer. These characteristics include:

  • Sparse furnishings: In order to keep costs as low as possible, warehouse clubs limit spending in areas that traditionally make for a pleasant shopping ambiance at other retailing establishments. Products are often displayed on pallets in a self-serve style, and customers wouldn't be surprised to find air conditioning ducts in plain sight. In other words, there's usually no confusion about the fact that you are in a warehouse and that the store is focused on efficiency rather than on delivering a luxurious shopping experience.
  • Low overhead: Many warehouse clubs invest little to no money in public relations, advertising, or marketing; they negotiate low prices with wholesalers for products they carry; they don't offer grocery bags or packing materials for customers; they use skylights to lower electricity costs; and they do other things to keep operating expenses at a minimum.
  • Limited selection: Warehouse clubs typically stock far fewer product choices than their retailing counterparts. Costco (NASDAQ: COST) carries fewer than 4,000 product offerings at a typical store, compared to more than 80,000 distinct products at Target (NYSE: TGT) and 100,000-plus at Walmart (NYSE: WMT) . Costco credits this limited selection for helping reduce complexity, increase inventory turnover, and lower costs.
  • High-volume product turnover: Warehouse clubs put up impressive sales numbers that usually leave rival retailers far behind. For example, each Costco store, on average, booked $176 million of revenue in the most recent fiscal year. That's more than three times the per-store volume at Home Depot (NYSE: HD) .
  • A wide sales base: The bulk-purchasing orientation of a warehouse club, combined with its tilt toward maximizing efficiency, means shoppers usually have to travel farther to visit their local store. Walmart operates nearly 5,000 retailing locations around the country, but Sam's Club, its warehouse club arm, maintains fewer than 600 stores that cover the same geographic footprint.
  • Low prices: All retailers trumpet their ability to offer low prices, but warehouse clubs achieve this goal thanks to the combination of the abovementioned operating efficiencies, plus the cushion provided by membership fee income. BJ's Wholesale Club (NYSE: BJ) estimates that it saves its members at least 25% on a basket list of popular grocery food and nonfood items. Costco summarizes its operating approach like this: "Our strategy is to provide our members with a broad range of high-quality merchandise at prices we believe are consistently lower than elsewhere."

The warehouse club industry started in the 1980s

Many of the warehouse clubs that we all know today started popping up around the country in the early 1980s. They are relatively new compared to the far more mature retailing industry. They typically sell a wide range of products, including fresh groceries, packaged food, apparel, consumer electronics, and home furnishings.

Warehouse retailing is highly competitive, with multiple well-established competitors present in nearly every major metropolitan area in the United States. Because of their varied selection, warehouse clubs compete against grocery stores, off-price retailers, convenience stores, and big-box retailers, among others.

The trends impacting the industry today are similar to those in the wider retailing world . Specifically, warehouse giants are seeing more of their business shift toward online ordering, so they are directing cash toward bulking up their fulfillment and shipping options to protect market share against online rivals.

How does a warehouse club make money?

The pressure to maintain the lowest prices, or "price leadership" as Costco calls it, has a negative impact on a warehouse retailer's bottom line. In fact, warehouse clubs consistently earn less than their traditional competitors.

This fact shows up in spades when comparing gross profit margin across warehouse clubs and other retailers. Costco's gross profitability is consistently below 13% of sales, compared to 22% for Kroger (NYSE: KR) and 29% for Target.

COST Gross Profit Margin (TTM) Chart

Costco Gross Profit Margin (TTM) data by YCharts .

Yet Costco and its warehouse peers operate primarily as subscription clubs rather than retailers, so it's helpful to look at its product sales as just a byproduct of the main retailing goal: to sell more memberships.

Membership fee income is generated whenever a subscriber signs up for an annual membership or renews their service for another year. These sales accounted for more than three-quarters of Costco's annual profits in the past year, and that is typical across warehouse clubs. Basically, a warehouse retailer earns next to nothing on the products it sells but profits instead by charging for access to its stores.

There are four main ways a warehouse club can increase its membership fee income. First, it can open new locations and thereby expand its addressable market. Second, the retailer can convince subscribers to upgrade to higher-tier (and more expensive) membership levels such as Costco's "executive" card. Third, a warehouse club can boost its annual renewal rate, leading to a larger membership base. And finally, the company can simply raise its membership rate.

Warehouse club metrics to know

If you're investing in a warehouse club, there are a few important financial metrics you should know. Some of them apply to traditional retailing peers, and others are more specific to the membership-based selling approach that warehouse giants take.

  • Comparable-store sales : This metric, also sometimes referred to as "comps" or "same-store sales," is a fundamental growth figure across all retailers, including warehouse clubs. It describes the change in revenue at locations that have been open for at least one year. In this way, comps strip out the potentially noisy details around store openings and closings to focus on how well-established stores are doing. Generally, investors like to see healthy comps, both when compared to the retailer's prior year and when stacked up against rivals across the retailing industry.
  • Gross profit margin: As mentioned above, gross profit margin, or the difference between gross profit and cost of goods sold, is generally lower for warehouse clubs than for other retailers. Still, it's an important metric for investors to track because changes here could impact their returns. An improving gross margin is ideal because it means the business is becoming more efficient. However, because of warehouse clubs' focus on price leadership, such gains typically don't translate into higher earnings as they do with traditional retailers. Instead, a warehouse club is likely to take any gross profit gains and direct them right back into price cuts to maintain its market share position.
  • Subscriber renewal rate: Broadly speaking, every initiative a warehouse club undertakes is in service of the primary goal of delivering unbeatable value to its members. That's why the subscriber renewal rate is such an important metric. It is an investor's best way to judge whether the company is pleasing its current members by offering a compelling mix of in-demand products at rock-bottom prices. A stable or improving renewal rate indicates success in this key retailing goal. A falling renewal rate, meanwhile, is a red flag suggesting a warehouse club is losing its edge against competitors.
  • Membership level: A rising membership base plays a critical role in supporting long-term profits. Look for successful warehouse clubs to report rising subscriber levels through a mix of new store launches, greater market penetration in existing locations, and higher renewal rates.

The benefits (and risks) of investing in warehouse clubs

Warehouse clubs vary in important ways from their retailing peers. Most of these differences are attractive for investors, but some aren't. Let's go over the key benefits and risks of investing in a warehouse retailer like Sam's Club or Costco.

A man purchasing eggs in bulk.

Image source: Getty Images.

Benefits of warehouse club investing

Warehouse clubs have a much more stable earnings base than retailers. They generate most of their income from membership fees, after all, which comes in the form of a once-a-year purchase. Thus, the ups and downs of the retailing world don't tend to impact a warehouse club as much as they do regular stores, whose earnings rise and fall with the day-to-day shifting of consumer sentiment.

Warehouse clubs are also fairly protected from price-based competition , whether it comes from physical retailing rivals or from online-only challengers. Because their prices are already about as low as possible, there's little room for another company to undercut them and steal market share.

Risks of warehouse club investing

These companies are susceptible to many of the same risks that affect traditional retailers, including the risk of a recession depressing sales or of consumer demand shifting toward the online selling channel. The e-commerce threat is also more challenging for large warehouse giants in that they don't maintain the massive store network that their peers enjoy. Thus, they can't simply retrofit existing locations to act as delivery and pickup hubs for online shoppers -- as Target has done in recent years.

A warehouse club arguably has lower brand loyalty , since it bases its entire operating model around low prices. This operating posture leaves it exposed to losing market share to any company that could offer sustainably lower prices.

The biggest warehouse club players

While the selection isn't as varied as in broader retailing, investors still have a wide range of stock options to consider. These include pure-play warehouse clubs, recent IPOs, and international upstarts. The chart below ranks warehouse clubs by annual sales, or the amount of revenue generated each year. Market capitalization refers to the total value that investors have assigned the business, and in Sam's Club's case, that figure includes the massive Walmart business as well.

Company

Yearly Net Sales

Market Capitalization

No. of Stores

Costco

$150 billion

$121 billion

787

Sam's Club

$58 billion

$322 billion*

599

BJ's Warehouse Club

$13 billion

$3 billion

216

PriceSmart

$3 billion

$1.8 billion

44

Net sales and store base metrics are for the most recent complete fiscal year. Market cap data is as of Aug. 20, 2019. *Sam's Club's market cap incorporates Walmart into its valuation. Sources: Yahoo! Finance and company financial filings.

Costco

Costco is by far the biggest warehouse club player, with its $150 billion of annual sales. That makes it the second-largest retailer on the planet behind Walmart. The warehouse giant first started trading its stock in 1980 under the name The Price Company, when it operated just a few locations in southern California. The company began trading as Costco in December 1985. Today it maintains nearly 800 warehouses in 11 countries. Costco counts more than 87 million cardholders and handles more than 2 million transactions per day.

The warehouse giant has been on an almost unbroken streak of operating and financial growth over the past decade. After dipping slightly following a change to its loyalty credit card in 2015, customer traffic bounced back in fiscal 2018. Costco's latest membership fee hike, combined with a record level of subscriber renewals, lifted annual earnings to more than $3 billion in 2018 compared to $2 billion just four years prior.

Sam's Club

Sam's Club is owned and operated by Walmart and is the industry's second-biggest retailer, with $58 billion of sales in fiscal 2019. The company has struggled to stand out against its larger rival Costco, which caters to a wealthier demographic. Comps were 5% in the last year, compared to 7% for Costco. After a string of annual market share losses, Sam's Club recently shrank its sales base by closing 63 underperforming stores .

The company remains a formidable competitor, though, and is supported by Walmart's massive sales base, global shipping infrastructure, and strong financial backing.

BJ's Wholesale Club

BJ's Wholesale Club only operates on the East Coast of the U.S., but it is well established in its core markets. In fact, it maintains roughly three times the number of clubs of any competitor in the densely populated Northeast. The company booked $13 billion of revenue in the most recent fiscal year, which translated into $300 million of operating income -- up from $184 million of profits four years earlier. BJ's promises to consistently save its members 25% or more on a representative basket of in-demand merchandise -- especially groceries -- and executives estimate that most members can save roughly 10 times their annual subscriber fee of $55 by handling most of their shopping through BJ's.

BJ's is relatively new to the stock market, having just gone public in July 2018. It is growing more slowly than its peers, with comps up just 2% in the past year.

PriceSmart

Often referred to as the "Latin American Costco," PriceSmart (NASDAQ: PSMT) is the only warehouse club focused exclusively on markets outside of the United States. The retailer targets Central America, the Caribbean, and Colombia, a region that's home to 100 million people.

While the area is far less competitive in terms of established rivals, PriceSmart's geographic focus brings major challenges, including more modest living standards, lower income, and sluggish economic growth. The retailer's sales in recent years have been hurt by recessions in areas like Panama and Guatemala , by currency devaluation in Colombia, and by hurricanes striking several of its Caribbean territories.

Nevertheless, PriceSmart's sales crossed $3 billion last year across its 41 clubs, and that total was up from $2.4 billion in fiscal 2014. Comps improved by about 2% in each of the last two years.

The retailer's operating income hasn't grown at nearly the same pace, though. That metric stood at $126 million in fiscal 2018, compared to $136 million in each of the prior two fiscal years.

Finding a good long-term warehouse club stock buy

After you've evaluated a warehouse club stock's core operating metrics, you'll want to try to judge whether shares represent a good buy . While prices vary among the group we've discussed, investors typically pay a premium for a company that can consistently outgrow peers both inside and outside of the industry. Stock investors also reward businesses, like Costco, that demonstrate strong subscriber metrics.

Valuations change daily, but there's plenty of consistency around the two main ways in which a warehouse club is priced. Investors will usually compare rivals on the basis of price-to-earnings and price-to-sales ratios, just as they do for traditional retailers. The price-to-earnings, or P/E, ratio describes the value of a business in terms of the multiple of annual profits. A P/E of 20, for example, means investors are willing to pay 20 times the past year's profit to own the stock. Price-to-sales, or P/S, is a similar comparison that uses a revenue multiple rather than earnings. These ratios don't tell you anything by themselves, but when compared to the broader market or to rivals, they help show whether a stock is priced at a premium, or discount, to peers and to the stock market.

As of mid-2019, Costco held a premium stock pricing, with shares trading at 32 times trailing earnings compared to 23 times for BJ's Wholesale and 15 times for Target. The warehouse club leader is also more expensive on a price-to-sales basis, with investors paying 0.77 times revenue for its stock compared to 0.62 times for Walmart, 0.49 times for PriceSmart, and 0.25 times for BJ's. Income investors might also prefer PriceSmart, Walmart, and Costco stocks over BJ's since they each pay a modest dividend .

Warehouse clubs also fit squarely in the " consumer staples " segment of the economy, meaning you can gain exposure to them as part of an investment in a broad index fund or exchange-traded fund (ETF). The Vanguard Consumer Staples ETF (NYSEMKT: VDC) is a popular option since it covers a wide range of stocks and carries a modest annual fee.

Bulking up

In most cases, warehouse club stocks are valued at a higher premium than traditional retailers' stocks to account for their more stable earnings profiles. However, just as in the case of the annual membership fee that warehouse shoppers pay, the stock price premium is often easily justified when choosing to own a strong big-box retailer like Costco. The club has a track record for consistently increasing earnings even when rivals are losing earnings power. Its huge base of loyal, subscription-paying shoppers also tends to buffer the business against the type of sharp downturn that can happen to most retailers at the start of a recession.

Thus, several of your biggest potential worries, including the fear of a recession-fueled earnings crash, are minimized. And if you purchase shares of a warehouse club, your portfolio gets to benefit from the continued shift toward this popular shopping alternative.

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Demitrios Kalogeropoulos owns shares of Costco Wholesale and Home Depot. The Motley Fool has the following options: short January 2020 $180 calls on Costco Wholesale, long January 2020 $115 calls on Costco Wholesale, and long January 2021 $120 calls on Home Depot. The Motley Fool recommends Costco Wholesale and Home Depot. The Motley Fool has a disclosure policy .

This article was originally published on Fool.com