Stay Clear From The Container Store (NYSE:TCS)

Specialty retailer of storage and organization products and solutions, The Container Store Group, Inc. (NYSE:TCS) has enjoyed a period of profitable growth over the last five years. Nevertheless, the firm has fared poorly on the stock market. This seems to be driven by the deterioration in free cash flow production and returns. The company remains unattractive despite a superficial appearance of attractiveness.

Poor Stock Market Performance

The Container Store’s share price has declined by over 14% over the last five years, compared to a rise of over 46% for the Russell 3000. This has occurred despite the company enjoying an era of profitable growth.

Despite a year in which investors have rotated to previously unloved performances, The Container Store has performed even worse, declining by nearly 47%, while the Russell 3000 has declined by nearly 10%. What seems to be driving this decline in the share price is the deteriorating returns on invested capital (ROIC) and free cash flow (FCF) that the company has experienced over the 5-year period.

The Business Model

The Container Store is a specialty retailer of storage and organization products and solutions in the United States, and the only national retailer solely devoted to the category. The company provides a collection of creative, multifunctional, and customizable storage and organization solutions, sold in stores and online. The company’s product offerings include Elfa Classic, Elfa Décor, Avera, and Laren closet lines, as well as the recently added wood-based closet line Preston closet. The company’s target customers are highly educated, busy homeowners with higher-than-average household incomes who are seeking solutions to simplify their lives and maximize their spaces. The company operates 94 stores in 33 states and the District of Columbia, and offers customers the choice of shopping in-store, online, or through in-home services. The company’s operations consist of two reportable segments: The Container Store and Elfa. The Container Store, with net sales of $1.0 billion in fiscal 2021, operates retail stores, websites, call centers, and in-home services businesses, while Elfa, with $70.9 million of third-party net sales in fiscal 2021, designs and manufactures component-based shelving and drawer systems and made-to-measure sliding doors.

The Container Store has two primary distribution centers that are used to distribute its products to retail stores and online customers. The first distribution center is located in Coppell, Texas and is made up of approximately 100,000 square feet of corporate office space and 1 million square feet of warehouse space. The second distribution center is located in Aberdeen, Maryland and is approximately 600,000 square feet, with the majority of its space being used for warehouse purposes. In 2021, as a part of the Closet Works acquisition, The Container Store added a domestic manufacturing facility in Elmhurst, Illinois. The company utilizes third-party truckload carriers to transport products to retail stores and major parcel carriers for direct-to-customer order deliveries. The Container Store uses logistics technology to optimize its operations, including receiving, picking, packing, and shipping. The company has a strong commitment to continuous improvement in its distribution centers and follows guidelines from the Centers for Disease Control and Prevention to ensure the safety of its employees. The Elfa brand utilizes a network of third-party carriers to deliver its products to customers worldwide.

Management has three strategic priorities, which are to deepen its relationship with customers, expand its reach, and strengthen its capabilities.

Strategic Pillar One: Deepening the relationship with customers involves enhancing the in-store shopping experience, launching a new branding campaign and logo, launching a new loyalty program, and engaging customers. The Container Store has reduced its dependence on promotions and has focused on enhancing the in-store shopping experience by adding store greeters, product demonstrations, and curated products. The new branding campaign and logo have resonated with customers and have resulted in increased sales. The new loyalty program, Organized Insider, rewards customer engagement and offers exclusive benefits.

Strategic Pillar Two: Expanding the reach involves expanding its manufacturing capabilities, increasing the number of design specialists, opening new stores, and enhancing its e-commerce capabilities. The Container Store has acquired and integrated a closet organization company to expand its manufacturing capabilities and has increased the number of design specialists to improve sales productivity. The company plans to open two new stores and has attractive growth opportunities in key markets for expansion. The e-commerce capabilities have been improved with enhancements to the site, such as improved browsing experience and smart filtering, and the company plans to continue to grow and improve the e-commerce experience.

Strategic Pillar Three: Strengthening the capabilities involves focusing on technology advancements and being an employer of choice. The company has added more payment options for customers, including a mobile point of sale solution and a mobile app, and has added new members to its company leadership team. The Container Store has conducted a pay equity study, launched a Supplier Diversity program, increased its minimum wage, and focused on its Environmental, Social, and Governance (ESG) strategy. The ESG strategy includes completing its first sustainability report, joining the U.S. EPA Green Power Partnership, and ranking as one of the top 30 participating retailers for its total green power usage.

Declining Returns and FCF

Revenue has risen from $857.23 million in 2017 to 1.09 billion in 2021, for a 5-year revenue compound annual growth rate (CAGR) of 5%. According to Credit Suisse’ (CS) “The Base Rate Book”, 28.8% of firms enjoyed a similar rate of growth over a 5-year period. That shows that the revenue growth has not been particularly exceptional. The mean 5-year revenue CAGR of the United States was 6.9%, and the median was 5.2%.

In the first nine months of the 2022 fiscal year, the firm has earned $787.54 million, compared to $787.57 million for the same period in the year prior.

Gross profitability declined from 0.66 in 2017 to 0.53 in 2021. This is still well over the 0.33 threshold that Robert Novy-Marx found marked out a stock as attractive. Firms with high levels of profitability tend to have high total returns.

Operating income has risen from $34 million in 2017, to $125.45 million, at a 5-year operating income 5-year operating income CAGR of 29.77%. Operating margin has risen from 3.97% in 2017 to 11.47% in 2021, highlighting the growing profitability of the core business. This is still short of the top quintile operating margin for the United States. In the first nine months of the 2022 fiscal year, operating margin has declined to 6.8%.

Net income has risen from $19.43 million in 2017 to $81.72 million in 2021, for a 5-year net income CAGR of 33.28%. Just 3.4% of firms enjoyed a similar rate of net income growth over a 5-year period. The mean 5-year net income CAGR of the United States was 7.3%, and the median was 5.9%.

The Container Store’s FCF declined from $34.53 million in 2017, to $23.6 million in 2021, for a 5-year FCF CAGR of -7.33%. In the first nine months of the 2022 fiscal year, FCF was -$27.7 million.

ROIC rose from 6.3% in 2017 to 12.6% in 2021. In the trailing twelve months (TTM), ROIC declined to 8.3%.

Despite declining FCF and returns, the firm has some competitive advantages going forward.

Competitive Advantages

The storage and organization category extends across many retail segments including custom closets, housewares, and office supplies. It is the only national retailer solely devoted to storage and organization. However, it faces competition from a variety of retailers such as mass merchants, specialty retail chains, and internet-based retailers, who dedicate a smaller portion of their merchandise assortment to storage and organization.

In the custom closet market, The Container Store competes with both national and regional custom closet companies, local home-builders and contractors. This market is highly fragmented and The Container Store differentiates itself by selling solutions rather than individual items.

The market is highly competitive, where there are many factors that determine the level of competition, such as service, product quality, price, location, reputation, customer loyalty, etc. The Container Store faces competition from both brick and mortar stores, as well as online retailers, which results in increased price competition and the customer’s selection of similar products. The company must respond to changing consumer preferences and trends related to e-commerce usage, which may result in increased costs. The Container Store’s competitors, some of whom have greater resources, may be able to benefit from changes in e-commerce technologies, which could harm the company’s competitive position. The company also faces competition from vendors who may sell similar or identical products to their competitors. Although the company has negotiated North American exclusivity on some products, a majority of their non-elfa products are not exclusive and the vendors could sell similar or identical products to their competitors, which could harm the company’s business.

In this highly competitive market, The Container Store’s competitors may have greater financial, marketing, and other resources, but the company competes based on its customer service, product selection and quality, price, convenience, consumer marketing and promotional activities, and its ability to identify and satisfy emerging consumer preferences. The Container Store’s strength lies in its solutions-based selling approach, highly trained employees, exclusive offerings, vendor relationships, passionate and loyal customer base, and the quality, differentiation and breadth of its product assortment.

The company’s competitive advantages can be summarized as follows:

1. Holistic Approach to Custom Closets: The Container Store offers a complete custom closet solution, including a full line of custom closets and a range of closet organization products, as well as in-home services. This sets the company apart from other brick-and-mortar and online retailers.

2. Experienced Sales Force: The company has a highly trained and experienced sales force with over 43 years of experience in selling custom-designed closet solutions.

3. Exclusive Distribution of Elfa Products: The Container Store is the exclusive distributor of Elfa-manufactured products in the United States, giving the company control over the sourcing and availability of its highest-selling and highest-margin products.

4. Vertical Integration: The Container Store’s vertical integration with Elfa allows for greater control over the supply chain, ensuring the availability of products and driving profitability.

5. Expanded Manufacturing Capabilities: The company has expanded its manufacturing capabilities with the acquisition of Closet Works, enabling it to offer a premium wood-based product line, which is expected to be margin accretive.

6. Personalized Customer Service: The Container Store’s employees are trained to offer highly personalized customer service, asking questions to understand customers’ needs and helping them find the solutions they need to improve their lives.

7. Multi-channel Retail: The company is a multi-channel retailer, with a fully-integrated website, mobile site and application, and call center, all of which help to enhance the customer experience and deepen loyalty.

8. Expansion Strategy: The Container Store has a disciplined expansion strategy, seeking out new store locations in markets that are primed for growth, both domestically and potentially internationally. The company also provides comprehensive training for employees, which enables new stores to deliver strong sales more quickly.

9. Unique Product Collection: The company offers a carefully curated collection of over 11,000 storage and organization solutions, with approximately 2,000 new SKUs introduced each year. Over half of the company’s sales come from exclusive or proprietary products, including 26% of private label products, which differentiates the company from other retailers.

Valuation

The Container Store has a price-earnings (PE) multiple of 3.98, which is obviously well off of the S&P 500’s PE multiple of 21.82. However, in the TTM period, FCF is around -$18 million, giving us a negative FCF yield. So, despite the PE telling us that the company is attractive, the underlying operational deterioration makes the stock unattractive.

Conclusion

The Container Store has been underperforming in the stock market, with a decline of over 14% in the last five years, compared to a 46% rise for the Russell 3000. This has occurred despite the company enjoying a period of profitable growth. The company specializes in storage and organization products and solutions and is the only national retailer solely devoted to the category. It also has some competitive advantages. However, declining ROIC and FCF seem to be driving the decline in the share price. With a negative FCF yield, the firm is a poor investment.