Many investors were bearish onCostco(NASDAQ: COST) as the wholesale retailer made its transition from American Expressto Visa.In this episode of Industry Focus: Consumer Goods, Vincent Shen and Fool.com contributor Dan Kline talk about how the company managed to make the switch with just a few minor stumbles, as they focus on the more pressing challenges the company is going to have to address in the next few years.
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The team also dives into Cabela's(NYSE: CAB) buyout by Bass Pro Shops. Find out why the outdoor sports giants are banding together, details behind the deal, and what this will mean for the combined entity going forward.
A full transcript follows the video.
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This podcast was recorded on Oct. 11, 2016.
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I'm Vincent Shen. Welcome to the latest episode of Industry Focus,the podcast that dives into a different sector of the stock market every day. It is Tuesday, Oct. 11, and I am joined via Skype by Fool.comcontributor Daniel Kline, who isbeaming in from an area of the countrythat has been in the headlines quite a bit recently --that's West Palm Beach in South Florida. How are you doing, Dan?
Dan Kline: I'm happy to say we're still here.
Shen: Yeah, Iwas really happy to hear thatyou guys came out OK following the hurricane. I heard it was pretty rough.
Kline: I don't want to minimize the people who actuallylost property or got hurt, but compared to what they were predicting,it wasn't that bad. It was very windy,very rainy, scary.I'm sure if you live right on the ocean,it was terrifying. But they were predicting 125 to 130-mile winds,and we only got about half that. So, we're very lucky.
Shen: Yeah. It seems likecertain regions were right in the path, others were able to avoid it. Overall, I think, especially in your situation,having just moved down to Floridain the past month or two,and having to encounter what was generally considered to be one of the biggest storms in recent memory,that's interesting timing, to say the least.
Kline: I'm hoping none of my neighborsput together that I have bad luck when it comes to the weather. They're predicting snow for next week.
Shen: Our twobig stories for today,first, we have the multi-billion dollar deal that wasrecently announced between the privately heldBass Pro Shopsand its major outdoor retail rival Cabela's, ticker C-A-B. Second, we'll take a look atinvestor favorite Costco, just to see how the company is faringafter its switch fromAmerican Express. Dan, let me provide a little bit of background forBass Pro and Cabela'sbefore we dive into the detailsbehind the buyout. In case anyone has never had the opportunity ofvisiting one of these storesbefore, or even heard of them,maybe if you're a die-hard city dweller, bothBass Pro and Cabela'sare two of the major big box storescatering to outdoor enthusiasts. They sell apparel, equipment, accessoriesfor activities like hunting, fishing, camping. That includes firearms as well.
With that, Dan,I'm going to let you take it away. Can you give us a little bit of detailbehind the deal?
Kline: These are two very similar companies. They each have around 100 stores, they each have around 20,000 employees. Andit was sort of the case of, given all the internet competition,there wasn't really room for two players. It's not necessarily that they have too many stores. But if you combine them, theirbuying power goes up, their branding goes up, their marketing goes up, or both go down,andit gets easier to not have to compete with each other when they're both looking atAmazonand other online retailersselling a lot of the same things.
It's worth noting that these aren't just stores. They're destinations. They're 180,000 to 200,000 and up square feet. They haveshooting galleries, live animals, restaurants that serve wild game. It's a really fun place to go. And in some ways, those have been the most resilient retailers -- stores wherethere's a reason to gowhen you're not necessarily going to buy anything.
Shen: Yeah.I want to point out, based on that, we were talking aboutbefore the show as well, it's really incredible, some of the attractionsthat their biggest flagship stores offer. ForCabela's, they take twodifferent approaches. They have theircurrent smaller storeapproach, think 40,000 to 100,000 square feet. Then,there's the legacy format, their larger stores, going up to 250,000 square feet, thebiggest location being in Hamburg, Pennsylvania. You mentioned shooting galleries and things like that. This has, of course, the shopping,but then a restaurant, aquarium,museum, animal displays forregional game for hunters. You can actually take a virtual tour of that store specifically withGoogleStreet View technologyto give you a sense of how large it isand what it has to offer.
Bass Pro Shop actually takes itto the next level. Their stores are largely in the 150,000 to 250,000 range for their Outdoor Worldflagshipbranding. The largest storein theBass Pro fleetis an unbelievable 535,000 square feet. They basically took overan old sports and concert arenain Memphis, Tennessee, called the Pyramid. Think of a former stadiumthat's now a big store that has two restaurants, a hotel, abowling alley, an aquarium, the tallest free-standing elevator in the worldwhich leads to an observation deckat the top of the Pyramid. The Pyramid itself isone of the tallest in the world. To put that in perspective, that 535,000 square feet for that store,by comparison, the averageWal-MartSupercenter-- which is huge,walking through that is its own experience -- they're only 180,000 square feet. So,this thing is just absolutely enormous.
Kline: It's worth noting that most of the Cabela's andBass Pro Shops are not in malls,they're in outlying areas,cheaper real estate. The big store hassomething important going for it. There's a reason to go there. I used to walk around with my son when he was four or five into one of these. But, we'd buy a little candy, maybe have lunch there.I'm not a big fisherman or hunter,but we would look at the stuff and play with the shooting gallery. And I spent a little bit of money. It was very crowded on the weekends, so the destination draws. Theproblem with that is, onTuesday, as someone who has a backgroundin retail,you don't have the same customer base. There's no families outon Wednesday afternoonlooking to browse and not buy. So,you have the positive that this huge storealmost functions as a museum. Butyou also have the negativethat, a lot of the week,it's not that busy.
So,going forward,there's a pretty big opportunity, and it sort of ties in to the Cabela's small format. You have all these malls around the country that have realized they can't just be stores. They have to havemovie theaters and bowling alleysand restaurants and other destinations to drive business,because people aren't shopping in retail stores the way they used to. A smaller-format Cabela's, maybe withone attraction, builds into that really well. You're going to see a lot of vacancies in malls. There's a lot ofSearsandK-Martanchor stores that aregoing to become vacant. And the new Bass Pro Shops/Cabela's isreally going to get some dealsto be able to expand, if that's what they want to do.
Shen: Absolutely.I love that idea, actually.They definitely have the attraction/entertainment aspect down. There's plenty of storiesand testimonials you can hear from customers,especially in the more rural parts of the country where these storescater to the people who are into fishing, gaming, and camping, wherethey will drive hoursto go to one of these stores,because the selection and the things to doare limitlesswhen you get to one of these bigger flagship locations.
Kline: This is really just a smart mash-up. Yousimply didn't need two companiesof a similar sizefighting with each other. As we've talked about,we saw this happened in sporting goods.Sports Authoritywent out, andDick'shas been thrivingbecause of it, because there's a certain amount of sporting goods -- andCabela's and Bass Pro Shop are loosely in the sporting goods space -- that you want to touch. Youdon't necessarily want to buy afishing rod that you've never handled. So, a certain percentage of peoplemight go into a Bass Pro Shop, handle thefishing rod, and then go buy itonline for cheaper. But, that person might at least buy somethingon the way out. Maybe they need some lures,maybe they really want some fudge, it doesn't really matter, they're going to spend money. Theydon't have to advertise to get you to notdrive down the road to Cabela's, andthat's an advantage.
Shen: Yep. Diving into a few of thedetails behind the deal. Keep in mind,Bass Pro Shop is privately held,where as Cabela's is publicly traded. So, the cash offer forCabela's was$65.50 per share. In total, that's about a $4.5 billion deal. Part of that deal, also, is Cabela's has its CLUB store co-branded credit card. That waspreviously managed by an entity they created, World's Foremost Bank. Part ofthe negotiation process was findingsome financial firm card processor to take overthat part of the operation.Capital Onewill be taking over that. There will beno change for customers themselveswho are part of the Cabela's CLUB,and also the Bass Pro side -- theyhave a card and loyalty program, too. So, all that will keepgoing in operationas the companies come together. The combined entity will actually have a network of about 180 stores and 40,000employees. The new company will also remain private, with the dealexpected to closein the first half of 2017.
Dan, did youhave a chance to pull up any info on the buyout premium? I have to say, overall,Cabela's shareholders should generally be pretty happybased on the previous trajectory that their stock had seenin the past year or so.
Kline: Yeah,it's about a 19% premium, if I remember correctly, overwhere the stock was trading when the deal was announced. It's one of those where you can't exactly saythat's all it is,because the stock had movedat various points asthis deal has beenrumored and talked about. This is one of those cases wherethe quarterback of the football teamand the head cheerleader, everyone wants them to get together,so eventually, they're going to go to prom togetherwhether they like each other or not.
What they're not talking about,because you don't want to scare people, isthere's going to be some synergy from this. There's going to be some cost-saving. They're going to keep both brands. Supposedly, they're going to keep bothheadquarters. But the reality is,if you have a guy who's in charge ofpurchasing sleeping bags at Cabela'sand a guy at Bass Pro Shop,there's no reason to have those separate, people. So you're going to start to see someback-office functionality. And maybe they'll haveseparate marketing teams. Maybe they'll haveseparate brands. But purchasing and payroll andsome of those things are going to come together,so it's going to get cheaper for these two brands to exist.
Shen: Alsokeep in mind thattheir geographic footprintof the store fleets themselves are pretty complementary. Bass Pro hasthe large majority of its storesin the eastern part of the United States. Only about a dozen locationsspread out between Colorado, California, Nevada, Arizona, and Washington. Cabela's adds about 30 to 40 more storesin those states in the western part of the country. So, while there's quite a bit of overlap toward the EastCoast,Cabela's gives Bass Pro Shopthat exposurein the more western states.
Then, going back to that premiumthat you mentioned, the 19%, that's to theOct. 2 close, right before the deal was announced. But when Cabela'sannounced that they were pursuing strategic alternatives back in December of 2015, since that point, that's a40% premium, that $65.60 per share. Then,if you go back even further than that, which ispart of the story ofwhy this deal even came to be, is that anactivist hedge fund, Elliott Management, they took an 11% stake inthe company in October, and immediately, they statedtheir intention to pushCabela's toward finding anentity to buy it out. Since that point -- about one year ago -- there's a96% premium since the Elliot Management stake wasdisclosed. Again, for a stock thathasn't tradedin the $65 range sincearound early 2014 -- the shares peaked around $71 during that period -- this is apretty nice takeaway for shareholders. I think a lot of people who came induring that peak are happy to recoup quite a bit of their investment.
Kline: Youhave to be happy. But the reality is,the reason the stock has gone up since this rumor has happened is,there was only one logical buyer, and a deal was going to happen. It wassimply the right thing to do. Even just looking at going from 100 stores to 180,you improve your supply lines, improve your warehouses. Even as you look at your online ability to fulfill orders, you now havelocations and warehouses,so you can leverage things like ordering online and picking up in stores. The stockbasically doubled since it became a rumor,because it just made so much sense. And now that it's happened, there'severy reason to believe it's the right move.
Shen: Yep. Finaltakeaway if you're Cabela's investor: As it stands right now,the offer from Bass Pro Shopvalues the company at about 22.5 times trailing 12-month earnings. So, quitefavorable based onCabela's outlook. Frankly, the company was in a tougher spot before Elliot Managementcame along and started pushing the company.
Kline: Yeah,it had a rough quarter. When you're looking at this type of store,comparable sales is really the metric. Comparable-store sales were down1.3% to the most recent quarter. That's not a disaster -- that's not Sports Authority numbers. But you look at all the people creeping up on it. You have a stronger Dick's,you have Amazon, you have various onlineretailers,REI, which is a much smaller-format store that inches up on this. So,you can see where the pressure was coming from. Getting bigger fastis a really good way to push back against that.
Shen: Thecompany ultimately had quite a few challenges to overcomeif they wanted to work on their revenue,their profitability, expanding theirnetwork of stores. Ultimately,you mentioned some of those other names,this is a retail environment thatdoes not take hostages.
Kline: Yeah. To wrap up,this is also a case where a healthy companywas having very negative stock pressurebecause of the short-term nature of many investors. Nobody was looking and saying, "OK, down 1.3%, butCabela's is well-positioned, it's in the right places, it has a type of store that's doing welleven in the internet economy." By going private, the company can now say, "We're going to invest, we're going to do certain things, and we'renot going to be tied to thequarterly reporting cycle." For aretail store in a quickly changing environment,that might mean shuttering the very bigstore, or making abig change to a format, or opening up 10 new mall stores,and that might not reflect well in the one, two, three quarter picture. But,as a private company, you can take the long view in a way that, frankly, retail companies can'twhen they're publicly traded.
Shen: But,one thing I will counter that withbefore we wrap up on this deal is that,the company, bottom line, net income fell 10% in 2014,another 6% in 2015, all this while revenue grew 11% over the same period. So, definitely,there are parts of the business that they needed to work on, frankly. Overall, in theoutdoor sporting goods industry, with this tie-up and combined entity,there's still a ton of competition. Keep in mind, you mentioned REI, there's also Dicks, you also mentionedGander Mountain, Big 5, Academy Sports,Modell's. Thatdoesn't even include the e-commerce side of it. Besides Amazon, there are a lot of smaller players that are pure plays online. So, Bass Pro with Cabela's,larger entity. I think they havea pretty bright future. But ultimately, on the investing side,Cabela's shareholders, there's not much to do at this point but see the deal go through. It'sexpected to close in the first half of next year.
Next up, wehave our discussion of Costco. Before we dig into the companyfollowing its breakup with American Express, I wanted to thank Tommy John for supporting the show.Tommy John is revolutionizing men's underwear with a focus on fit, fabric, and function. Shirts that stay tucked, socks that stay up,and underwear that keeps everything in place, whichever way a man moves. It's funny that, when Iwas still wearing a suit everyday for work, I thought that all guys suffered togetherand were willing to put up with socks that would bunch up around your shoes every hour,having to retuck your shirt all the time. The Foolmight let me get away with more casual dress around the office,butafter having the opportunity to wearTommy John gear,I have seen the light. Think of it like a mattress. You invest in thatbecause you spend a third of your life sleeping. Well, you spend most of the remainingtwo-thirds in underwear most of the time. Tommy John can make that two-thirdsof your day so much more comfortable with its breathable, lightweight, non-pilling and quick-drying fabrics. Tommy John offers awide selection of styles, and the company provides a best-pairguarantee. If their underwear isn't the bestyou have ever worn, it's on Tommy John. As a special offer to our listeners,get 20% off your first order by going to tommyjohn.com/fool and using the promo code "fool". Plus,you can get free shipping on any orderover $50. That's tommyjohn.com/fool, with promo code "fool".
All right, Dan.Costco. This is right in your wheelhouse.I know you've been following this company for some time. Can you give us some background?I mentioned American Express a few times. What exactly happenedwith this transitionthat they've made toVisa?
Kline: Costco switched from itslong-term credit card provider, American Express, to Visa. It wasvery much an abrupt transition,at least in the stores. There was messagingfor almost a yearto card holders. But basically, you went intoCostco on June19, and you could use yourAmerican Express. When you went inon June 20,that card no longer worked. The retailer no longer even took American Express at all,and you had to use your new Visa card. When that happened, the media exploded. "Oh my God!People are going to leave Costco! They'renever going to handle this, this is a disaster!"
Some of its rivals,BJ'sandSam's, offered free entry to their stores forpeople holding the old cards. It had seemed like they made a mistake. That was backed up a little bitby the fact that Citigroup, which provides the cards, wasoverwhelmed with calls, about 1.5 million callsin the first few days. It seemed likepeople were having big problems, it was causing checkout problems, andthis was going to create some real ill will. The reality is, things smoothed out pretty quickly.Within a few days, thecall volume was well down. I talked about with some of the Citigroup people about this. Oncepeople figured out the switch, they realized, "OK,now I have a Costco Visa, not aCostco American Express." Andthe rewards were actually a fairly decent amount better, anextra percent on gas and some tick ups across the board. This was played up likeit was going to be a huge drag on earnings. I think -- you have some of the numbers in front of you -- it just wasn't.
Shen: I think the company specifically mentioned inone of its recent reports that theswitch to Visa from AmEx hassaved the company enough money in fees to offset some of the falling-throughprices that it's seen that havenegatively impacted its business. So,we see that the transition wasn't the end of the world, wasn't as big of a negative impact thata lot of people fearedit would be. That was definitely a news cyclethat got a lot of headlines. But what about longer-term outlook forCostco? Something I know they've had challenges with is with e-commerce, that's been lagging,it seems like it's passing them by entirely. What do you think?
Kline: I don't want to say I expectthe bottom to fall off Costco. I think there's a certain percentage of its users that, "Internet be damned, it's fun to go to Costco and sample things that you wouldn't sample." Like,someone has cut up a Twizzler into little pieces --you know what a Twizzler tastes like,but it's still fun to get one for freeas you walk around andlook for bargains and hunt for things, andcome home with a pallet of meatballseven though you're a vegetarian. There's sort of the thing about going to Costco that'salways going to protect some of their business. But as you mentioned, they've done very littleon the internet. They send emails,they have some Web specials. But for the most part,it's not a great shopping experience,it doesn't feel like going to Costco in any waywith the bargain hunting. It's not what they've built on.
I do expect that, at some point,people are going to realize that the cost savingsaspect of Costco -- you pay your $55 membership so you cansave money bybuying whatever it is, your toothpaste for your breakfast cerealin bulk quantity to save money. The problem is -- and,I'm a Costco member and an Amazon Prime member --many of the things I used to buyfrom Costco ininconvenient quantities can be purchased from Amazon in the amount thatI actually want them in. So,instead of having to buy sixdeodorant sticks,and I have to remember where they areover the next eight months or however long it takes to use them,I could just order the same thing from Amazon at roughly the same price. Costco has not had major salesdips because of this, but atsome point, you have to think they're going to.
Shen: Yeah.I think, it's kind of similar to the topic we were talking aboutpreviously. Maybe not as directly. Bass Pro and Cabela's create these attractions. But at the same time, I have been to a Costco onFriday evening and seen whole families there,and it's the Friday night entertainment. It's very amusing to see. Andpowerful, I think, as part of Costco'sbusiness model. This warehouse modeltranslates very well to that in-personshopping experience. Now, how do you take thatappeal and attractivenessof the warehouse bulk shopping experienceand translate that into e-commerce,especially in a situation where,arguably, in most cases, those bulkorders and the savings you get translate to more expensive logistics for the companyto get that item or order to you? It'sgoing to be difficult.
Kline: Absolutely. I'm guilty,I spend a Sunday afternoon entertaining my 12-year-oldby promising him a $1 churro at Costco, and walking around. I mean,you can eat --I can't, I have a gluten allergy -- but they have cheappizza and hot dogs. People will go and have lunchand browse the storeand come home to find a book on sale, or something ridiculous they never planned for. I don't think you can replace that aspect. I think the problem is,there are some interesting digital thingsyou can do in bulk.
Amazon has actually beat them to the punch. Amazon owns a company called Woot.com. I don't know if you've ever heard of Woot,but what they do is a sale of the day. It's now morphed into more than that, but basically, they take a few items that they purchased --on clearance, likely, from someone else, orhave in their own warehouses that wouldn't sell -- and they put out, "OK,today we have thisHPlaptop, it's $249," andthat's maybe half of the regular price. And people go crazy and buy them.I know I buy a lot of t-shirts from them.I've ordered things and thought, "Oh boy! It will be great to have a 12-pack ofHDMI cables!"
I think that's very much like the Costco experience. You go to their websiteevery day, and you don't knowwhat's going to be there. Then, you make a purchase that might not be the smartest purchase. Costco could do that. They have a user base. They could even do it on a broader level. They could put a car on sale,they could put health insurance on sale, or, "Comeinto a store and get a hearing aid exam." There'sa lot of ways that Costco could leverage its physical stores, itsability to buy product. If you've ever watched Shark Tank,whenever we talk about Costco, they'renotorious for negotiating, getting the price down and getting things very cheap. So it's not crazy to thinkCostco could say, "OK,Christmas is in 10 weeks,we're going to have a different toyevery day on our deals site," and mimic that in-store experience.
Shen: Ifthey are able to successfully launch something like that-- and,I do know of Woot,but I did not know that Amazon had taken it over. That's news to me. Ultimately,this is a company with $120 billion intrailing-12-month revenue. And in that time, their net income margin is usually around 2% or less. So,profitability is really thin. People talk about the business benefitsfrom those membership fees --
Kline: It'sroughly 70%, 66% to 70% of profits,depending on the quarter.
Shen: There you go. That would be somethingthe company has to manage and work around as theytransition to e-commerce. That issomething they will really have to invest in and face off against, andrealize it's a do-or-die situation atsome point in the future.
Kline: There are some trends. TheCostco members, overall, are good. When you look at thesame-store sales, and yousubtract out the fact that gas prices are a dragbecause gas prices have been lower,they actually post some slight gains. It'sbasically flat when you factor gas in. That's not bad. But when you look at the membershipnumbers, overall membership revenues are upbecause they've managed to transition some people into moreexpensive memberships -- eitherbusiness membership, and in a couple of countries, they've raised prices. But the overall renewal rates have ticked down a very slight amount,about 0.1% when you look atthe different markets. That is by no means a cause to panic. It couldabsolutely be that a small amount of people, with the credit card, just went, "Nah,I never really used this, I'm not going to take the new credit card."
About85% of the credit cardportfolio moved over,which is pretty close totheactive number of peopleon the old credit card. So, that 15%that wasn't active,some of them might have said, "Nah,I'm not going to renew this, I'm just going to cut this card in half and not pay my membership fee this year." So, these aren't warning signs. They're almost like baby warning signs. You look at them and it's like, "OK,if they start to lose 0.1% here and 0.1% there,at what point does it snowball and become renewal rates going from 89% to 83%?" Then itbecomes a real problem.
Shen: Absolutely. OK,I take it that you're still relatively bullishwithCostco, and think the prospects will be able to --
Kline: I think they have a lot of time.I think there's an absolute flaw in their business. Theypretty openly said they don't care that much about the internet, and they'll get to it when they get to it --I'm really paraphrasing,nobody said anything that brash. That's indirectly what they said. But, I thinkbecause of the nature of their businessand the fact thatthe mall as a destinationhas maybe faded, that Costco as a destination can buy them two or three years tofigure out an internet strategy, orfigure out more things like gas, that youcan't buy on the internet. Amazon is not aneffective delivery method for a tank of gas. So, if Costco canbring me in for gas, an eye exam, a hearing aid exam, maybe they'll add haircuts,maybe they'll expand their restaurants,it doesn't necessarily have to bedirectly competing with Amazon. Just has to be continuing togive people reasonsto pay that $55 and occasionally visit the store.
Shen: Yeah. Well, that is all the time we havefor today, but you cancontinue the conversation with us, as always, and the rest of the Industry Focus crew, via Twitter @MFIndustryFocus, orsend us any questions or comments via email at firstname.lastname@example.org. Peopleon the program may own companies discussed on the show,and The Motley Fool may have formal recommendations for oragainst stocks mentioned, so don't buy or sell anythingbased solely on what you hear during the program. Thanks for listening and Fool on!
Daniel Kline has no position in any stocks mentioned. Vincent Shen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com, Costco Wholesale, and Visa. The Motley Fool recommends American Express. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.