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Wholesale Clubs: Membership Has Its Privileges

Investors should own firms able to deploy gas or food as a loss leader.

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Two basic staples, food and fuel, are eating a greater share of household budgets with prices growing at a faster rate than consumers' wages. Investors seeking to limit downside risk in the consumer defensive sector should own firms with business models that have the ability to deploy these inelastic products as category loss leaders.

Our moat analysis finds that companies able to use gasoline or food as a product loss leader have the least relative downside risk in an excessive inflationary environment. We believe wholesale clubs are the best positioned when food and fuel costs begin to strain consumer budgets, followed by the dollar stores and then the supercenters. Not withstanding current valuations, we find companies in these subsectors have the least risk to a decreasing denominator in any valuation multiple, because same-store sales (excluding fuel) increase when gas prices rise dramatically. With the exception of  Whole Foods (WFM) and  Kroger (KR), which also maintain or increase customer traffic when gas prices rise, we believe traditional grocery store operators are the most vulnerable.

  • Warehouse clubs, such as  Costco (COST), derive most of their operating profits from membership fees. Therefore, when necessary, these clubs can deploy their competitive advantage of offering gasoline and food without a retail markup to maintain customer traffic trends.  BJ Wholesale Club (BJ) recently reiterated that its relatively lower gas prices are helping drive market share gains in other categories.
  • Despite higher prices on a unit basis compared to supercenters and wholesale clubs, shorter travel distances and dollar pack sizes for necessities appeal to consumers living from paycheck to paycheck, driving customer traffic and sales at the dollar stores.
  • Kroger, to a greater degree than other traditional grocery store operators, foregoes the typical $0.10-$0.12 per gallon (net of credit card fees) profit margin on gasoline to drive market share gains. As a result, Kroger's comps excluding fuel increase when gas prices rise (see chart below).
  • We believe Whole Foods is more protected than other food retailers, not because of its ability to sell gas at wholesale prices as Kroger does, but simply because the firm's customer base is the least sensitive to price increases in our consumer defensive sector.

If Wages Continue to Lag Inflation, Consumers Could Shift Channels Again
Most consumers in benign or adequate wage growth periods do not appear to be motivated price seekers. However, now that both fuel and food at home prices are moving ahead of wage growth, we believe there is increasing risk that U.S. consumers become motivated price seekers once again, similar to the prior recession. Moreover, with the food manufacturers' Producer Price Index (PPI) currently running in the high single digits from a year ago, it will be some time before the impact from rising commodity prices works through the food supply chain. In our view, this likely does not bode well for sales in nonessential categories. But defensive stocks still could get hurt because these input costs eventually work their way to store shelves. Clearly, this could have a negative impact on margins if firms decide to hold prices in check. If companies choose to raise prices in order to maintain margin rates, then volumes are likely to get hurt. This is despite the inelasticity of basics such as fuel and food because switching costs for consumers are nonexistent. Therefore, in the consumer defensive sector, we believe investors should seek to own business models that have the ability to sell these necessities essentially at cost. These companies should capture any of the incremental price seekers resulting from paychecks not keeping up with rising food and gas prices.

Regression Confirms Our Moat Analysis
Wall Street often seems to have a misguided obsession with the R-squared. However, correlation is not causation, which is why we focus on the F statistics and corresponding P-values, rather than add random variables in an attempt to increase the R-squared. In the most basic definition, a significant F-stat says that some relationship exists between variables that cannot be explained by random error. We find a very meaningful F-stat of over 70 and supporting P-values, which makes us comfortable that Kroger's comps in the store, not just at the gas pump, accelerate two out of three times when gas prices move higher. Or for the R-squared obsessed, Kroger's comps improve 64.9% of the time when gas prices increase. Still, we need to take a step back from the data and look at the bigger picture. Once consumers are motivated to become price seekers, the business models that have the ability to deploy gasoline (or food as well for the wholesale clubs) as a product loss leader have the least relative downside risk to revenues. Overall product margin rates still will take a hit, but not margins and sales, which likely will be the case for the weakest players in the weakest industries.

Morningstar Analysts does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.