In Part Two of this Deep Dive, we provide an overview of the warehouse-club sector.

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1 June 5, 2017 In Part Two of this Deep Dive, we provide an overview of the warehouse-club sector. The 40-year-old global warehouse club sector is estimated to generate approximately $191 billion in revenues in The clubs business model seeks to limit gross profits so as to offer low prices to members while generating profits for shareholders through reasonable membership fees. The majority of the clubs are located in the US, which accounted for nearly three-quarters of sector revenues in The market is dominated by three companies: BJ s Wholesale Club, Costco Wholesale and Sam s Club (a division of Walmart). The US warehouse club sector grew at a 7.2% CAGR from 2001 through Its growth rate outpaced that of the total US retail industry by 3.3 percentage points over the period. The international market grew at an even brisker 10.8% CAGR. Yet the sector s growth rate slowed over the same period, actually hitting zero in And researchers are forecasting that the US segment will grow at a 2.4% CAGR, more than 1.5 points lower than overall retail, from 2016 through The spoiler behind the sector s decelerating growth rate has likely been e-commerce, which the clubs have been slow to embrace. Warehouse clubs currently generate 4% or less of their revenues from e-commerce. As is the case with many other retailers, warehouse clubs need to develop a strategy to compete with e- commerce players, as well as leverage their unique strengths to adapt to other demographic and technological changes. 1

2 Table of Contents June 5, 2017 Deep Dive: Warehouse Club Stores Executive Summary... 3 Warehouse Club Companies at a Glance... 5 Warehouse Club Advantages... 6 Economies of Scale Maximize Efficiency... 6 Expanded Product Mix Attracts Shoppers... 7 alue, Treasure Hunt and Organics Appeal to Consumers... 8 In the Sweet Spot of the Weinswig Retail Hourglass... 9 Warehouse Club Challenges Generational and Demographic Changes in Shopper Preferences E-Commerce Amazon Everywhere Conclusion

3 Executive Summary Warehouse club stores have had a great run in the 40 years since 1976, when Sol Price founded the first Price Club, which ultimately became today s Costco. The clubs were initially open only to business customers, but later allowed employees of nonprofit and government organizations to join, and eventually opened to the public. The clubs had a unique business model limiting profitability so as to pass the savings on to customers and making the bulk of their profits from membership fees. Customers love the clubs low prices, the ability to buy in enormous quantities and the delight of finding unexpected bargains in treasure hunts throughout the stores. There are not many stores in which customers can purchase a 20 lb. package of steaks, a flat-panel T and a diamond engagement ring all in one trip. The warehouse clubs have successfully leveraged postwar demographics, generally situating themselves in suburban areas with high median incomes and many small businesses to serve, offering consumers in those areas the convenience they need. While shoppers in such areas tend to be affluent, everybody loves a bargain, so many well-off consumers shop the warehouse clubs along with their more price-conscious neighbors. 3

4 June 5, 2017 Deep Dive: Warehouse Club Stores The clubs popularity has shown up in their financials. From 2001 through 2016, US warehouse club revenues grew at a CAGR of 6.2%, outpacing the 3.0% annual growth rate of the overall retail industry by more than three percentage points. The sector s growth outside the US was even more brisk over the same period, averaging 10.8%. Profitability did not suffer, either. Despite the clubs vow to limit gross margins in order to offer attractive prices, the top three US warehouse clubs generally have seen operating margins of around 2% 4%. Despite this prosperity, growth has slowed over the past 15 years, and global growth ground to near zero in 2015, making it an inflection point. Now, the US segment is forecast to grow annually at about 2.4%, less than half a point higher than the total retail industry. The slowdown can be attributed to changes in demographics and the ways people shop and, of course, to the steady growth and encroachment of e-commerce. In 2016, e-commerce accounted for 8.1% of US retail and grew by 15.1% year over year. What should the warehouse clubs do to recapture their previous appeal to consumers and reignite the growth rates of years past? Clearly, e-commerce is part of the answer. Among the major warehouse clubs, e-commerce s share of sales is likely highest at Costco, where the channel accounts for 4% of revenues. One short-lived but interesting player in the e-commerce field was Jet.com, which Walmart acquired in Jet attempted to combine the low prices of warehouse clubs with the convenience and ease of e-commerce and m-commerce. The company also implemented some innovative ways to reduce shipping costs. The warehouse clubs need to leverage their unique strengths, which include providing high-quality goods at low prices and providing customers with a treasure hunt experience, as well as offering strong private-label brands. Costco s Kirkland Signature private label accounts for about one-quarter of the company s sales, making it a $30 billion brand. Kirkland Signature products are available on Amazon.com and Jet.com, and the label is arguably a major international brand in its own right. Warehouse clubs also need to adapt to the changing demographic patterns of American suburban life. Members of younger generations are increasingly living in cities rather than in suburbs. In urban areas, living space and storage are at a premium, and many urban dwellers do not own a vehicle that they can drive to a warehouse club and fill with large, bulky purchases. To meet these consumers needs, warehouse clubs should explore offering more of their goods in smaller quantities online and also explore delivery methods that e-commerce companies are using, such as click-and-collect and expedited shipping. In this deep-dive report, we offer an overview of the warehouse club sector, analyze the key factors that are influencing the sector and profile the major players, as well as provide suggestions on what warehouse clubs can do to recapture the strong growth they saw in previous periods. 4

5 Warehouse Club Companies at a Glance Figure 1. Selected Metrics for the Big Three US Warehouse Clubs, 2016 Category BJ s 1 Costco 2 Sam s Club 3 Financial Net Revenues (USD Bil.) $15.0 $119.6 $57.4 YoY % Change 4.0% 2.5% 0.9% E-Commerce s Share of Revenues (Last FY) N/A 4.0% 2.8% * Membership Fee Income (USD Mil.) $270 $2,683 $1,348 Gross Margin 16.5% 13.8% 16.0% Operating Profit (USD Mil.) $294 $4,211 $1,671 Operating Margin 2.0% 3.5% 2.9% Membership Number of Members (Mil.) Percent Business 25% 55% 20% Percent Consumer 75% 45% 80% Avg. Annual Household Income (USD) $59,600 $74,000 $45,000+ Membership Fee Basic/Premium (USD) $50/$100 $55/$110 4 $45/$100 Avg. Annual Membership Fee Revenue per $25 $32 $23 Member (USD) 5 Stores Number of Clubs US and Puerto Rico Number of Clubs International Number of Clubs Total Total Store Area (Mil. Sq. Ft.) Average Store Size (Thous. Sq. Ft.) Products Number of SKUs 7,000 4,000 6,000 Number of Private-Label SKUs Number of Private-Label Brands Other Avg. Sales per Club (USD Mil.) $70 $168 $87 Avg. Sales per Sq. Ft. $637 $1,168 $659 Avg. Sales per Employee (USD Thous.) $571 $554 $497 Avg. Sales per Member (USD) $1,362 $1,405 $970 *For parent company Walmart Source: Company reports/emarketer/us Census Bureau/Fung Global Retail & Technology 1 BJ s was acquired by several private equity firms on September 30, The company s last public filing was for the fiscal year ended January 2011; all subsequent figures are estimates. 2 Figures for Costco in this report are calendarized (Costco s fiscal year ends August 31), unless otherwise noted. 3 Figures for Sam s Club consider the fiscal year as having ended in December of the prior year. 4 Costco announced that, effective June 1, 2017, the membership fee for all US and Canada Gold Star (individual), Business and Business addon members will rise to $60, and that membership fees for Executive members in the US and Canada will rise to $ Average fee revenue is below the membership fee due to free memberships (e.g., Costco provides a free household card with all paid memberships). 6 Sam s Club s international stores are reported under Walmart s International segment. 5

6 Warehouse Club June 5, 2017 Deep Dive: Warehouse Stores Advantages Warehouse clubs offer members the lowest possible retail prices, sometimes reaching wholesale levels. A large membership base enables the clubs to purchase large volumes at low cost. Beyond that, limiting the number of SKUs they purchase to just 4,000 8,000 enables warehouse clubs to purchase even larger volumes in fewer categories, which helps them maintain a cap on gross margins on behalf of their customers. Economies of Scale Maximize Efficiency Warehouse clubs offer members the lowest possible retail prices, sometimes reaching wholesale levels. A large membership base enables the clubs to purchase large volumes at low cost. Beyond that, limiting the number of SKUs they purchase to just 4,000 8,000 enables warehouse clubs to purchase even larger volumes in fewer categories, which helps them maintain a cap on gross margins on behalf of their customers. In this way, the sector achieves economies of scale that competitors in other retail formats including the mass merchandise, discount, consumer electronics and supermarket formats cannot easily achieve, given their larger offerings of 25, ,000 SKUs. In many categories, consumers can find substantial savings at warehouse clubs. Compared with prices at local grocers, for example, the average savings can be 65% or more. A limited merchandise selection also enables the clubs to maximize efficiency in product distribution, handling, stocking and merchandising. Fewer SKUs drive superior inventory turns, too. Since the narrow choice leads to sales of what is available, as long as the items are desirable, those sales drive inventory turns. While the clubs actual gross margin dollars may be below those of mass merchants or supermarkets, greater turns generate more in gross margin dollars per SKU. 6

7 Expanded Product Mix Attracts Shoppers Costco s revenue share by category has remained fairly constant during the past five years, though foods, fresh foods and softline goods have experienced slight increases. Together, foods and fresh foods represent more than one-third of Costco s revenues. While selling national brands (in both food and nonfood categories) at very low prices is the clubs value proposition, the chains are increasingly selling privatelabel products and adding businesses, such as gas filling stations, pharmacies, auto maintenance services and optical centers. The figure below shows that Costco s revenue share by category has remained fairly constant during the past five years, though foods, fresh foods and softline goods have experienced slight increases. Together, foods and fresh foods represent more than one-third of Costco s revenues. Figure 2. Costco Revenue Breakdown, by Category 18% 17% 17% 16% 15% 10% 11% 11% 11% 12% 16% 16% 16% 16% 16% 22% 22% 21% 21% 21% 13% 13% 13% 14% 14% 21% 21% 22% 22% 22% FY12 FY13 FY14 FY15 FY16 Foods Fresh Foods Sundries Hardlines Sonlines Other Source: Company reports 7

8 June 5, 2017 Deep Dive: Warehouse Club Stores alue, Treasure Hunt and Organics Appeal to Consumers Warehouse clubs appeal to consumers on a number of fronts aside from offering value. They also offer a shopping experience that has a treasure hunt aspect, as certain items may be available only during a single visit, rather than every time a shopper visits the store. Warehouse clubs appeal to consumers on a number of fronts aside from offering value. They also offer a shopping experience that has a treasure hunt aspect, as certain items may be available only during a single visit, rather than every time a shopper visits the store. In addition, the clubs appeal to their members by offering a range of organic items, which have grown in popularity over recent years. The bargain: Warehouse club members enjoy knowing they are getting the best deal possible. The no-frills shopping environment of the clubs, along with their lack of advertising, communicates the value proposition to members no unnecessary expenditures will threaten the savings passed along to members. (Multivendor mailers paid for by warehouse clubs are used for marketing, but these often contain coupons that make the deals even better.) Little luxuries and big luxuries: Frugal warehouse club shoppers still want luxuries, and the club format offers those at very competitive prices. The combination of high-end and low-end products makes warehouse clubs even more of a destination for shopping. As the Weinswig Retail Hourglass model below illustrates, high- and low-end retailers are enjoying success, while those in the midmarket are not faring as well. Warehouse club members can afford to splurge on a few luxury items by trading down on other items in their shopping cart. The treasure hunt: A steady flow of high-end, unique merchandise is a constant at warehouse clubs, creating a treasure-hunt experience for shoppers. This merchandising strategy includes a buy it now factor, as a product may not be in stock on the member s next visit. Moreover, saving money by shopping in a warehouse club allows consumers to justify the reward of a value-priced treasure. Treasures at Costco include a changing assortment of fine jewelry and the Polish Stoneware collection in housewares. At Sam s Club, a KitchenAid grill was recently offered at a 30% discount to its original, $1, price tag. About 25% of Costco s revenues derive from treasure-hunt items, according to a recent Forbes article. Organics: Warehouse clubs pride themselves on discovering new items that will interest their affluent membership and generate sales. Organic is the new buzzword in food and health and beauty aids and, for warehouse club operators, organics represent their core sector tenets, combining quality and the fun of a treasure hunt with exclusive and hard-to-find products. Costco more than doubled its number of organic offerings from 50 a few years ago to more than 130 in The company recently exceeded $4 billion in annual organics sales, bypassing Whole Foods Market to take the number-one spot in terms of organics sales. Generally, organics have a higher price point and higher profit margin than do nonorganics, driving up the average transaction value. 8

9 Although performance varies by chain, budget-friendly warehouse clubs have benefited from the bifurcation in US retail, characterized by Fung Global Retail & Technology s Weinswig Retail Hourglass model. In the Sweet Spot of the Weinswig Retail Hourglass Although performance varies by chain, budget-friendly warehouse clubs have benefited from the bifurcation in US retail, characterized by Fung Global Retail & Technology s Weinswig Retail Hourglass model. The model illustrates that premium stores at the top end, such as Nordstrom, and budget retailers at the value end, such as Walmart, are flourishing. Meanwhile, midmarket department stores, such as JCPenney and Kohl s, are languishing. Figure 3. The Weinswig Retail Hourglass Model Source: Fung Global Retail & Technology The hourglass model itself is representative of the shrinking middle class in the US. Median household income has resisted growth since hitting a peak of $57,843 in It nearly returned to its previous high in 2007 before falling to a recent low of $52,605 in

10 June 5, 2017 Deep Dive: Warehouse Club Stores Figure 4. US: Median Household Income (USD) $60,000 $58,000 $56,000 $54,000 $52,000 $50,000 $48,000 $46, Median Income 1999 Peak Source: US Census Bureau According to the Pew Research Center, the US wealth (net assets) gap between upper-income and middle-income families is now the widest on record since 1983, at 6.6 times, reflecting no wealth growth for middle- and lower-income families. Data from 2012 underline the three-decade saga of middle-class stagnation. Against this macroeconomic backdrop, it is no surprise that the middle ground in US retail is under pressure. Fortunately for warehouse clubs, frugality has become the new normal in the postrecession recovery. While that frugality certainly plays to the competitive advantages of warehouse clubs, the clubs also benefit by touching upon the luxury end of the Weinswig Retail Hourglass, as they offer some luxury items at very competitive prices to indulge customers. Fortunately for warehouse clubs, frugality has become the new normal in the postrecession recovery. While that frugality certainly plays to the competitive advantages of warehouse clubs, the clubs also benefit by touching upon the luxury end of the Weinswig Retail Hourglass, as they offer some luxury items at very competitive prices to indulge customers. The clubs ability to play at both the high and low ends of the retail market is powerful. 10

11 Warehouse Club Challenges Generational and Demographic Changes in Shopper Preferences Much has changed in retail in the 60-plus years since entrepreneur Sol Price opened his very first store, a FedMart, in an airplane hangar in San Diego, California. In the intervening decades, we have seen Walmart rise to prominence, the advent and expansion of the Internet and e-commerce, and significant changes in demographic and social trends. The rise of warehouse club stores seems predicated on the suburbanization in the US that picked up after World War II, which drove an increase in consumption and the consumer economy. Younger consumers are more likely to share assets, such as cars, and to use public transportation which makes transporting bulk quantities of goods from a warehouse store impractical and unwieldy. In recent years, it has become fashionable, particularly among twentysomethings, to move back to urban centers, which are characterized by small apartments rather than by the large houses common in suburbs. These younger consumers are more likely to share assets, such as cars, and to use public transportation which makes transporting bulk quantities of goods from a warehouse store impractical and unwieldy. Moreover, the low prices and convenience offered through e-commerce, mobile commerce, and subscription and other services make it possible for shoppers to have goods easily shipped to their homes now, eliminating the need to drive and load a vehicle at a warehouse store. These are only some of the challenges that warehouse clubs face in terms of future growth. 11

12 June 5, 2017 Deep Dive: Warehouse Club Stores E-Commerce E-commerce continues to grow at a much faster rate than US retail overall, and to represent an ever-greater share of the market. In the first quarter of 2017, the e-commerce channel accounted for 8.5% of total US retail commerce, and grew at 14.7% year over year, on a seasonally adjusted basis. Figure 5. E-Commerce s Share of US Retail Sales 9% 8% 8.5% 7% 6% 5% 4% 3% 2% 1% 0% Data are seasonally adjusted. Source: US Census Bureau In recent quarters, this curve has steepened, indicating an acceleration of e- commerce s share gains at the expense of traditional brick-and-mortar stores. In the first quarter of 2017, the e- commerce channel accounted for 8.5% of total US retail commerce, and grew at 14.7% year over year, on a seasonally adjusted basis. 12

13 Amazon Everywhere Amazon is building on its early success in disrupting the markets for books and media by steadily continuing to move into new product categories, including grocery and apparel. The company is uniquely able to leverage both its IT infrastructure (through Amazon Web Services) and its continually developing delivery infrastructure, which serves to reduce its fulfillment costs but can also be employed for grocery delivery. Source: Shutterstock Amazon s Prime membership program works similarly to a warehouse club membership: members pay an annual fee for access to the program and its benefits Amazon s Prime membership program works similarly to a warehouse club membership: members pay an annual fee for access to the program and its benefits. Among other benefits, Amazon Prime members receive free two-day shipping, access to Amazon s audio and video offerings, access to free books, and access to other exclusive services such as the Echo connected intelligent device, Dash reordering buttons, and the Amazon Prime Now smartphone app, which enables users to receive one- or two-hour delivery in selected cities. AmazonFresh is a grocery delivery service that is exclusive to Prime members. The service costs an additional $14.99 a month on top of Amazon Prime, and deliveries are free for orders over $40. Members can order fresh produce and groceries, including specialties from local shops and markets, for same-day or next-day delivery, and can select a time for delivery. Part Two of the report examined the advantages and challenges warehouse clubs face. Part Three discusses 10 topics affecting the warehouse club sector and retail in general. Conclusion Part Two Part Two of the report examined the advantages and challenges warehouse clubs face. Advantages include the economies of scale while providing significant value pricing to customers and a treasure hunt shopping experience that offers unexpected surprises and bargains. Challenges the warehouse clubs face include shifting shopper preferences due to generational and demographic changes, the steady encroachment of e-commerce, and Amazon s entry into multiple areas of commerce. Part Three discusses 10 topics affecting the warehouse club sector and retail in general: the changing grocery shopper, e-commerce, mobile commerce, robotics in retail, private labels, the sourcing revolution, ancillary products and services, US market saturation, international expansion, and the brief independence of Jet.com. The report concludes with profiles of the top three US warehouse clubs and an analysis of the attractiveness of selected global markets. 13

14 June 5, 2017 Deep Dive: Warehouse Club Stores Deborah Weinswig, CPA Managing Director Fung Global Retail & Technology New York: Hong Kong: China: John Mercer Senior Analyst John Harmon, CFA Senior Analyst Amy Lin Research Assistant Hong Kong: 8th Floor, LiFung Tower 888 Cheung Sha Wan Road, Kowloon Hong Kong Tel: London: Marylebone Road London, NW1 6JQ United Kingdom Tel: 44 (0) New York: 1359 Broadway, 9th Floor New York, NY Tel: FungGlobalRetailTech.com 14