Discount Retailers: Not Going Out of Style

Summary

Some businesses fly under the radar and are far better than one would initially suspect. They quietly compound capital at high rates of return and ward off competitors using subtle but sustainable business models. The familiar names of Ross Stores, TJ Maxx, and Burlington Stores, which I’ll refer to from now on as discount retailers, have thrived by offering excellent value on brand name merchandise to customers for many years.

Customers aren’t the only ones that have benefited from their low prices. Shareholders have been rewarded handsomely by these high-return, recession-resistant businesses over long periods of time. In this article I’ll take a look at what drives their business model and what the future might look like for the companies and their investors.

Business Model

Retail fashion is a fickle industry where consumer tastes are subject to rapid change. One thing that does not change is people’s desire for a good bargain on quality items. Discount retailers have harnessed this fact of life and consistently offer brand name items for 20-70% off regular prices. As you can imagine, buying brand name items at a discount does not go out of style during recessions, and these businesses have proved resilient through cycles. As an example, see the chart below of TJ Maxx sales performance through recessions.

The value proposition is straightforward – low prices on in-demand merchandise – making money on the value proposition is a different story. Anyone can sell an item at a discount; the trick is actually profiting on each item. Discount retailers have a simple, but defensible, model to earning high returns on products selling at a substantial markdown. With subtle differences between the three major players, there are four common tenants that drive this model:

- A refined, opportunistic buying process

- Strong win-win relationships with manufacturers and vendors

- The “Treasure Hunt” effect

- Low operating cost structure

These allow discount retailers to buy merchandise at a significant discount and run a lean operation resulting in excellent returns on capital.

Buying Process

Perhaps what draws me to the discount retailers is that they are simply value investors at heart. Much like a value investor buys stocks that others cannot or will not, and therefore is offered a discount, these businesses buy merchandise when others cannot or will not.

These retailers obtain merchandise at a significant discount from manufacturers by opportunistically taking advantage of an imbalance in retailers’ demand and manufacturers’ supply. Most of the buys are “close-out” purchases – made late in the buying cycle and when a manufacturer has an overrun or a canceled customer order. This creates an excess supply of clothing or other items where the manufacturer simply needs to salvage some of its costs, and they know who to call when this happens.

The concept of buying merchandise when there is a supply-demand mismatch is straightforward but implementing it at scale is no small task. Buyers at Ross, TJ Maxx, and Burlington are seasoned procurement professionals typically with years of experience from other leading retailers such as Walmart or Target. It’s not every day that brand name manufacturers encounter an overrun or large cancellation, so these buyers must maintain constant contact with thousands of vendors to find the next purchase and maintain a consistent flow of fresh items to their stores.

For example, in Ross Stores’ 10K they outline that their vendor base consists of more than 7,500 suppliers which they continuously monitor for sourcing opportunities. Buyers review their merchandise assortments on a weekly basis resulting in distribution locations receiving new items three to six times per week. Ross also outlines that their primary buying offices are located in New York and Los Angeles – the nation’s two largest apparel markets. These strategic locations allow buyers to build relationships with local vendors and keep a daily eye on negotiations and sourcing opportunities. Building the network of suppliers and process of uncovering buying opportunities is not something that can easily be replicated at scale, providing a reasonable degree of protection to the top players. Below is a summary of the value creation process outlined in a recent Burlington Stores presentation.

Source: Burlington Investor Presentation

Simply stepping in as buyers when there is a supply overage allows discount retailers to buy at below-market prices, but this alone is not responsible for the extreme discounts you’ll find when browsing a Ross or TJ Maxx store.

Win-Win Manufacturer Value Proposition

When selling to a traditional retailer, manufacturers must make host of concessions as a “ticket to play”. Retailers typically require the manufacturers to provide things like promotional allowances, advertising allowances, return privileges, drop shipments, and delayed shipments. All of this adds up to more costs and less flexibility for the manufacturers and a higher sticker price for retailers. Discount retailers generally waive all of these provisions, allowing manufacturers to shed the associated costs and sell at the lowest prices possible.

A constant one-sided advantage between a buyer and seller usually results in either poor economics or an unsustainable relationship. The win-win nature of discount retailers helping manufacturers in a flexible manner when they encounter supplier overages creates an enduring partnership and interdependent relationship that should continue to benefit both sides. This relationship allows discount retailers to obtain the best price from manufacturers and incentivizes the manufacturers to do more business with the discount retailers because they know they will get a fair deal when they need it.

Not only does the opportunistic buying process enable low prices, but it also creates a unique shopping experience that customers cannot easily find elsewhere.

Treasure Hunt Experience

You never know which brands and which items will be subject to the next close-out sale, and therefore every time a customer walks into one of the discount retailers it turns into a treasure hunt of sorts. Stores are laid out so that customers can walk throughout the store and quickly assess vast arrays of merchandise racks. Customers will often go to the stores knowing they want a specific item – maybe a blouse or a bathroom mirror – but they have no idea what brands they will find that match what they are looking for. When the shopper discovers a winner there is often a limited supply (because of the unpredictable nature of close-out buying) which creates an element of “if I don’t buy this now, somebody else will”. Unlike traditional retailers, many items are unlikely to reappear in the store once sold, which creates a scarcity feeling for shoppers, again driving sales.

Another important aspect of the treasure hunt experience is that it provides some level of protection against ecommerce threats. Just like Ross, TJ Maxx, and Burlington, Amazon and other online retailers offer plenty of items at a lower cost than traditional retailers. What online players can’t replicate is the same in-person experience of hunting for a brand name bargain - an enjoyable process for the discount shopper. I’m not arguing Ross Stores has a wider moat or is a better business than Amazon, but the two serve somewhat different purposes for customers which is why they each should continue to thrive.

Opportunistic buying feeds the treasure hunt experience, and the treasure hunt experience helps feed the final aspect of profitable returns – low operating costs.

Low Operating Cost Structure

Discount retailer store layouts driven by the treasure hunt experience are tailored for a self-service shopping experience which requires less staff at each location. Shoppers aren’t fitted for clothes and all of the merchandise is arranged in a visible manner allowing the stores to only staff essential workers to keep the stores running.

Also, the previously discussed centralized merchandising, marketing, and purchasing decisions drive economies of scale with respect to general and administrative costs. Finally, flexible store layouts result in low construction and conversion costs, again helping to keep operating costs down.

To pull all of this together: Ross, TJ Maxx, and Burlington opportunistically buy merchandise at a discount from manufacturers when there is an imbalance in supply and demand. They waive concessions for additional marketing and promotional provisions for the manufacturers, allowing for even lower prices. The opportunistic buying process results in a low-cost treasure-hunt experience which cultivates a loyal customer base in all economic conditions and enables low operating costs. These elements allow discount retailers to earn superior returns on capital, which we’ll explore next.

Returns on Capital

We love to focus on studying industries where all of the players generally do well because of enduring advantages of the business model – and discount retailing certainly fits the bill. Below are return on capital metrics for Ross, TJ Maxx and Burlington. Because of their effective sourcing methods, low operating cost structures, and efficient use of stores and inventory, all of these businesses earn excellent 30%+ returns on capital (debt + equity). Incremental returns are strong as well, implying continued value creation opportunities, with Ross leading the pack on both fronts.

As a reminder, we define incremental return on capital (I-ROIC) as incremental operating cash flow divided by invested capital (cash retained in the business). The incremental returns look back over the last 10 years and use normalized operating cashflow margins.

Burlington maintains strong results but lags the other two likely because of the lower, less mature store base which leads to less efficient scaling of SG&A and lower sales per square foot.

The lower current returns are partially offset by a potentially longer growth runway at Burlington given the lower store count, which should lead to operating leverage and margin expansion. Burlington also has an opportunity to improve efficiency at existing stores to close the gap with Ross and TJ Maxx, but that success there cannot be assumed.

Growth Potential

Despite years of consistent growth, it appears each discount retailer still has room to run. As is the case with most retailers, sales growth is driven primarily by increases in same-store sales and new store locations.

The potential store counts are provided by management at each company. In my view Burlington, and probably TJ Maxx as well, is providing quite conservative guidance for potential store counts and is likely to over-deliver. The same can be seen with Costco, who consistently raises guidance for the overall store count potential.

Taking average same-store sales growth (3-5%) over the last several years combined with annual new locations (5-10%), each business should certainly be able to achieve high single-digit if not low double-digit topline growth for many years.

As the incremental returns show, building new locations is accretive to profitability and creates value for shareholders. Intrinsic value over time should increase roughly as a function of the rate the company can reinvest in growth and the returns they earn on that invested capital. Per share results will benefit from excess capital being returned via dividends and buybacks (yield). For each business, prospects appear bright. The table below shows reinvestment rates, I-ROIC, and expected yields for each company resulting in anticipated per share intrinsic value growth.

Not surprisingly, given the similarity in the business models, I’d expect each company to compound at similar rates which should hover around 10% over the long term. Ross and Burlington have both experienced nice margin expansion over the last 10 years, so earnings per share have grown faster than 10%, and there is probably a bit of additional upside there. I think it’s reasonable to assume Burlington’s incremental returns start to converge closer to Ross and TJ Maxx’s as the store count increases and matures, though Ross has clearly proven to be the leader in terms of efficiency and return on capital and I don’t see why that changes any time soon.

Valuation and Returns

Because these businesses earn high returns on capital, are recession resistant, and have attractive growth opportunities with a decent moat, they generally trade at premium valuations. Each business historically has traded in the 18-22x earnings range, and we’ll call 20x a fair price for a business with these attributes in the current interest rate environment.

Ross and TJ Maxx look fairly priced and I would expect the stocks to produce 10-11% annually from current prices, with Burlington looking somewhat more expensive leading to sub-par single digit stock returns.

I like these businesses as they employ a straightforward, durable, and replicable value creation process that is reasonably predictable out into the future. They create value for customers and manufacturers in a way that other retailers have difficulty competing with which leads to high returns on capital. If one of these above-average companies becomes available for a below-average price, say less than 15x normalized earnings, I think they look very interesting and would produce mid-teens annual returns for investors.

Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.

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