The Container Store: Now Is The Time To Short

| About: The Container (TCS)
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Let's be honest… it's extremely tough to short high flyers in a market that just keeps going up. Investors stop worrying about valuation, and think about potential. Even if a high flyer is priced to perfection, it's usually best to wait until we see the first sign of weakness, which will gives investors reason to rethink their position. Lucky for us, The Container Store (NYSE:TCS) just gave us the slip-up necessary to put on a short position in the name with its recent earnings report. Additionally, the expiration of lock-up periods in May will give the company a significantly higher float, which will help with supply and demand dynamics, and should put downward pressure on the stock price. When we take a look at the future of TCS, it's still almost fully priced for perfection. I have a $30 price target on the stock.

Business Overview

TCS is the leading specialty retailer of storage and organization products in the United States. The retail segment (knows as TCS) provides organizational supplies to consumers for their home. The stores are pretty large, with an average 19,000 sq ft of retail space per locations, and do about $9.5MM in average unit volumes. The stores ramp up very quickly, which makes the company less reliant on comps (and as we will show later makes it tougher for the company to get incremental productivity out of the stores. The company has a plan to grow stores from the current base of 63, to over 100 locations nationwide, which could provide for +10% sq footage growth for the next several years. As the company grows stores, they should be able to leverage fixed costs (about 40% of SG&A is fixed in nature). Because of this, the company has a goal of growing EBITDA margins from their current 10% range to 15% over time.

Along with the retail segments, the company has a wholesale segment called Elfa. Elfa, designs and manufactures component-based shelving and drawer systems that are customizable for any area of the home. In addition to supplying the TCS segment, which is the exclusive distributor of Elfa branded products in the United States, Elfa sells to various retailers and distributors in more than 30 other countries around the world on a wholesale basis. This is one of the growth vehicles for the company, yet sales have declined year-over-year for the past two years. The company will try to raise average ticket by getting a higher percentage of installation (the company makes about 25% on a sale if they install it), but considering the multiple the company currently trades at, it's very concerning to see year-over-year declines in this business.

The company went public in November 2013 and the stock has more than doubled since that time. Another questionable thing I see is that most of the proceeds from the transaction were used to cash out private investors, instead of paying down the company's debt balance (just over $20MM was used, which is about 10% of the proceeds). The company still has over $300MM of debt on the balance sheet.

Catalyst #1: Weak Earnings Report

On Tuesday, the company reported worse than expected results. Traffic declined approximately 1%, which was a sequential improvement, but not good enough to justify the current multiple. Elfa sales were down 4% if you exclude discontinued items, which again causes me some concern. SG&A expense increased 9% year-over-year, and also increased as a percentage of sales. Though most of this was attributable to IPO costs, it's still worse than what was priced into the stock.

Here's the story, when you have a stock trading at 70x next year's earnings, considering the growth profile of the company, you really can't have anything go wrong with the business. These results weren't bad, they were just worse than what was priced into the stock. Again, it's tough to short a high flyer until there's something that gives investors a pause. This latest earnings call puts into question traffic growth opportunities, especially considering how tough it is to get incremental productivity out of the stores, and also puts into question Elfa's turnaround, which is the main driver of higher ticket and margins. Now, investors have a chance to re-evaluate their position in the names, and I expect many investors to continue to take profits.

Catalyst #2: Lock-Up Period Expiration

The other big catalyst for our short position is the upcoming lock up period expiration. Though there are currently 48MM shares outstanding, only 15MM of those shares are being traded due to lock up provisions. This creates a supply and demand imbalance that has helped propel shares to their lofty valuation. By May of this year, all lock ups will have expired, which will put another 33MM shares into the market. Many of these shares are held by insiders and employees who will want to cash out some of their profits in the company. This will help fix the supply and demand imbalance and put downward pressure on the stock. Now that the company has put out worse than expected results, investors should start to look past the potential of the company and begin to have a greater focus on this upcoming downward catalyst.

Base Case

Considering today's lofty earnings multiple, I think it's better to try and understand the company's performance over the next several years to see if the company can grow into this valuation under more normalized conditions. I believe the base case scenario for TCS is that the company opens 7 units annually (not 10%), reaches their growth target until they reach 100 stores and then growth begins to slow once they hit this mark, and also hits their 15% EBITDA margin goal over time:

2014

2015

2016

2017

2018

2019

2020

TCS Sales

743.4

817.8

892.1

966.5

1,040.8

1,093.9

1,147.0

Elfa Sales

92.1

97.7

104.5

112.9

120.8

129.2

138.3

Total Sales

835.6

915.5

996.6

1,079.3

1,161.6

1,223.2

1,285.3

COGS

342.6

373.5

404.6

436.1

467.0

489.3

511.5

Gross Profit

493.0

542.0

592.0

643.3

694.6

733.9

773.8

SG&A

392.7

427.5

462.4

497.6

532.0

556.5

581.0

EBITDA

100.3

114.4

129.6

145.7

162.6

177.4

192.8

D&A

33.2

36.5

40.2

44.2

48.6

53.5

58.9

EBIT

67.1

77.9

89.4

101.5

114.0

123.9

133.9

Interest

19.1

17.1

15.1

13.1

11.1

9.1

7.1

EBT

48.0

60.8

74.3

88.4

102.9

114.8

126.8

Taxes

16.8

21.3

26.0

30.9

36.0

40.2

44.4

Net Income

31.2

39.5

48.3

57.5

66.9

74.6

82.4

EPS

$ 0.65

$ 0.82

$ 1.01

$ 1.20

$ 1.39

$ 1.55

$ 1.72

As you can see, under our base-case scenario, the company hits the 100-store level in 2019, at which point growth begins to normalize. We get 2020 revenues of $1.3B and EPS of $1.72. At this point, year-over-year EPS comes in at 15%, but slowly drops thereafter. For my valuation, I will be using a 17.5x multiple (1.2x PEG) on 2020 earnings:

2020 EPS

$1.72

Valuation @ 1.2x PEG

$30.10

2010 EBITDA

$192.8MM

Valuation @ 9x EBITDA

$29.23

2020 Sales

$1.26B

Valuation @ 1.5x Sales

$32.46

Blended Valuation

$30.60

Upside/Downside

21.5%

Even under a scenario where the company is able to execute properly, grow stores, and expand margins, 2020 performance does not justify the current price level.

Downside Scenario

The downside case scenario for TCS is that the company opens 6 units annually as they are constricted by real estate opportunities, sees growth return in the Elfa business but only to the mid-single digit level, and is only able to leverage costs to the 13% EBITDA level:

2014

2015

2016

2017

2018

2019

2020

TCS Sales

743.4

817.8

881.5

945.2

1,009.0

1,072.7

1,136.4

Elfa Sales

92.1

96.8

101.6

106.7

112.0

117.6

123.5

Total Sales

835.6

914.5

983.1

1,051.9

1,121.0

1,190.3

1,259.9

COGS

342.6

374.0

401.1

428.1

455.1

482.1

509.0

Gross Profit

493.0

540.5

582.0

623.8

665.9

708.2

750.9

SG&A

392.7

428.9

460.1

491.2

522.4

553.5

584.6

EBITDA

100.3

111.6

121.9

132.5

143.5

154.7

166.3

D&A

33.2

36.5

40.2

44.2

48.6

53.5

58.9

EBIT

67.1

75.0

81.7

88.3

94.8

101.2

107.5

Interest

19.1

17.1

15.1

13.1

11.1

9.1

7.1

EBT

48.0

57.9

66.6

75.2

83.7

92.1

100.4

Taxes

16.8

20.3

23.3

26.3

29.3

32.2

35.1

Net Income

31.2

37.7

43.3

48.9

54.4

59.9

65.2

EPS

$ 0.65

$ 0.78

$ 0.90

$ 1.02

$ 1.13

$ 1.25

$ 1.36

Under this scenario, the company still hits 100 stores by 2020, but never sees the EPS growth necessary to come close to justifying today's valuation. Again I will be using 1.2x PEG (12x since they will only grow EPS by 8-10% after 2020) in my valuation of 2020 operating performance:

2020 EPS

$1.36

Valuation @ 1.2x PEG

$16.32

2010 EBITDA

$166.3MM

Valuation @ 8x EBITDA

$20.80

2020 Sales

$1.26B

Valuation @ 1.25x Sales

$25.90

Blended Valuation

$21.01

Upside/Downside

44.9%

As we can see, under the downside scenario, we get an above-average grower that never really justifies the current multiple. In this scenario, an investor could see a profit of 45% by shorting the stock at its current levels.

Upside Scenario

Under the Upside scenario, the company maintains 10% square footage growth throughout the rest of the decade, announces the possibility for additional locations, and beats margin goals by hitting the 18% EBITDA margin level:

2014

2015

2016

2017

2018

2019

2020

TCS Sales

743.4

817.8

899.6

989.5

1,088.5

1,197.3

1,317.1

Elfa Sales

92.1

96.8

101.6

106.7

112.0

117.6

123.5

Total Sales

835.6

914.5

1,001.2

1,096.2

1,200.5

1,314.9

1,440.5

COGS

342.6

371.3

402.5

436.3

473.0

512.8

556.0

Gross Profit

493.0

543.2

598.7

659.9

727.5

802.1

884.5

SG&A

392.7

424.3

458.5

495.5

535.4

578.6

625.2

EBITDA

100.3

118.9

140.2

164.4

192.1

223.5

259.3

D&A

33.2

36.5

40.2

44.2

48.6

53.5

58.9

EBIT

67.1

82.3

100.0

120.2

143.4

170.0

200.4

Interest

19.1

17.1

15.1

13.1

11.1

9.1

7.1

EBT

48.0

65.2

84.9

107.1

132.3

160.9

193.3

Taxes

16.8

22.8

29.7

37.5

46.3

56.3

67.7

Net Income

31.2

42.4

55.2

69.6

86.0

104.6

125.7

EPS

$ 0.65

$ 0.88

$ 1.15

$ 1.45

$ 1.79

$ 2.18

$ 2.62

We see some very impressive results under this scenario, but still must realize that the company is currently trading at 15x 2020 upside earnings. Let's take a look at the company's valuation under this scenario:

2020 EPS

$2.62

Valuation @ 1.2x PEG

$45.85

2010 EBITDA

$259.3MM

Valuation @ 10x EBITDA

$47.10

2020 Sales

$1.44B

Valuation @ 1.75x Sales

$45.58

Blended Valuation

$46.18

Upside/Downside

18.41%

Under this scenario, we get a price target of $46, which coincidently lines up with the recent top on the stock. I believe that this top helps provide greater resistance at this price level, which helps reduce the downside in a short position.

Valuation

Now that we have our range of scenarios, let's take a look at our valuation:

Valuation

Probability

Base Case

$ 30.60

50%

Downside Case

$ 21.01

30%

Upside Case

$ 46.18

20%

Total Valuation

$ 30.84

I am using a valuation of $30 (23% downside), but considering the fact that we just had the slip up necessary to make investors and analysts question their "priced to perfection" valuations, I could see this valuation coming to fruition fairly quickly. Additionally, if the company is unable to correct traffic issues, combined with the additional shares that will come to market in May, I could see the stock falling over 40%. I believe that the downside to a short position is $46 as I believe we would need new news in order to see a higher price, which would make us re-evaluate the position.

Risks

Risks for a short position include (these were covered in our upside scenario):

  1. The company is able to reverse traffic trends
  2. The company is able to improve costs, and eventually beats their 15% EBITDA margin target
  3. The company is able to successfully grow square footage by 10% annually for the foreseeable future, and eventually adds another 100 locations to the store base
  4. The company is able to rejuvenate the Elfa business where it becomes a double-digit growth vehicle

Catalysts

Catalysts for a short position include:

  1. The recent earnings report, which put a "chink in the armor" of a stock that was priced to perfection and should make investors and analysts reconsider their position on the company
  2. The upcoming lock up expirations, which end in May
  3. The company grows their store count by 6-7 units annually (in line with their 2014 guidance), which is below analyst estimates.
  4. Real estate risk - the company may not be able to find enough good locations to meet growth expectations. Even if they do, adding 8-12 locations annually to keep up the growth rate creates greater risk on execution and lowers the ability for the company to make sure every location really fits their concept.
  5. The company isn't able to reach their 15% EBITDA margin target. I believe an additional catalyst for the stock would just be confirmation of the 15% EBITDA margin goal, as I believe investors are forecasting a better number.

Conclusion

We understand the company is basically priced to perfection at its current valuation, but we needed the catalyst necessary to short the stock. We just got that catalysts with the recent earnings report, which should help investors look past possible potential and look more towards the current valuation and upcoming lock up expirations. I have a $30 price target on the stock, with additional possible downside.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.