Off-Price Retailers: No E-Commerce, No Problem
Summary
- The off-price retail model depends almost entirely on foot traffic — the impact from online sales is negligible.
- Near term pricing pressure is expected as retailers sell lockdown inventories at a steep discount.
- Key opportunities lie in fashion brands, department stores and suppliers liquidating out-of-season merchandise to off-price retailers, at bargain-basement prices.
- Off-price retailers will come out a winner during the pandemic, and I believe ROST has the most upside potential at current prices.
Investment Thesis
Off-price retailers generate the bulk of their total sales from brick-and-mortar stores, a negative for the public during this pandemic. However, the markets are missing the opportunities that off-price retailers will have in the near future - particularly with other retailers and suppliers liquidating their out-of-season merchandise to off-price retailers, at rock-bottom prices. Their main value propositions of offering customers low prices and a treasure-hunt shopping experience, combined with strong company fundamentals and financial stability during recessions, make off-price retailer stocks a great addition to a long-term investor's portfolio.
E-Commerce Is Not An Option
Earlier this year, retailers across the U.S. (and the globe) faced unprecedented challenges as the pandemic spreads, forcing states to mandate store closures for non-essential businesses. Unfortunately, off-price retailers belong to this group of non-essentials. While they enjoyed lower electricity bills, off-price retailers generated near-zero revenue during the period when stores were closed, due to their lack of online presence. Ross Stores (ROST) and Burlington (BURL) have a purely bricks-and-mortar business model, while T.J. Maxx (TJX) had launched its e-commerce line in prior years. As a result, ROST and BURL are down more than TJX, year-to-date. The S&P Retail ETF (XRT), however, is up 4% as of this writing.
(Source: TradingView)
The markets have such a negative sentiment on off-price retailers because of their heavy reliance on brick-and-mortar play. Even though TJX has its own e-commerce operations, its online sales only make up a minuscule portion of total sales. In 2019, TJX's online sales account for only 2% of total sales. BURL had also launched its own online store but decided to shut it down due to underperformance — e-commerce only accounted for 0.5% of sales in 2019. ROST's and BURL's lack of online presence explains why their stocks are down more compared to TJX. In addition to e-commerce, TJX has a more diversified store portfolio with Marmaxx, HomeGoods, and TJX International, which explains its outperformance among peers. Although a mere 2% of online sales is better than none, the markets seem to be overestimating the benefits online sales have on these companies, as well as underestimating the off-price retailers' bricks-and-mortar business during this pandemic.
The lack of digital sales can be attributed to the off-price retail business model and its main value proposition. Off-price retailers offer customers with a self-service, treasure hunt shopping experience. The key phrase here is "treasure hunt" — customers have no knowledge of what's in store, and therefore, they have to "hunt" for the items in their shopping list. Although a rare occurrence, the prospect of finding a $2,000 Air Jordans for the price of $60 is also an exciting feature shopping in off-price retail stores. Simply put, the treasure-hunt experience, coupled with bargain prices, are what drive customers to these stores.
(Source: Google Images)
Another reason why online sales don't work for this business model is due to the timing of merchandise purchases. A Fortune article outlines the purchasing process between department stores and off-price retailers:
Unlike department stores, which order products six to nine months ahead of time and tend to buy an item in its full assortment of sizes and colors, the off-price giants make purchases much closer to when the items will hit shelves and don't need to have every size of something to buy it. And they are constantly bringing in new items: Ross, for instance, gets fresh merchandise delivered three to six times a week.
With fresh inventories coming in every month or so, updating the website product catalog this frequently is not only unproductive but also a headache. Furthermore, off-price retailers have a massive network of manufacturers and vendors to buy from (ROST has about 7,500) where products will vary immensely across different suppliers. Off-price retailers also make purchases created by manufacturer overruns and canceled orders both during and at the end of a season (known as "close-out" purchases), making the type, amount, size, and color of leftover merchandise available for purchase very unpredictable.
All in all, both the treasure-hunt shopping experience and timing of merchandise purchases do not make online selling a viable option. Most importantly, the off-price business model is set up to succeed without e-commerce. When asked about e-commerce, both ROST and TJX dismissed the idea of making e-commerce their main sales channel:
"I would say strategically nothing will change in terms of the total TJX. We will not look to e-commerce as our major leveraging point to get us through COVID and out the other side it'll be complimentary as it always is." — Ernie Herrman, CEO of T.J. Maxx
"On e-commerce, I'd say our view has not changed at this point. Our focus and efforts are going to be on safely and profitably reopening our bricks-and-mortar stores this year." — Michael Hartshorn, COO of Ross Stores
Near-Term Pricing Pressure For Off-Price Retailers
Since the government-imposed shutdown of non-essential businesses in March, the majority of retailers have been scrambling left and right to manage their liquidity position. Some of the measures taken were furloughing employees, cutting capital expenditures, reducing executive pay, deferring rent payments, and canceling orders. Macy's (M), Kohl's (KSS), and Gap (GPS) were among the vast number of major retailers that canceled orders or extended payment terms with suppliers. This puts suppliers in a relatively tough spot as they become cash-strapped and their facilities loaded with merchandise that might soon-to-be out-of-season.
Just like their suppliers, major retailers might also have a large inventory built-up due to their inability to sell merchandise because of store closures and social distancing measures. Since the lockdown happened in spring, much of the spring and summer merchandise is left unsold. A number of retailers including ROST and GPS have written down the value of their merchandise, as springwear becomes "seasonally irrelevant." These retailers will have to clear out their inventory before the back-to-school and holiday seasons, and the only way to do so at a rapid pace is through deep discounting. Such a synchronized move of discounting will create a temporary influx of overly-cheap merchandise in the market, adding more pressure for off-price retailers. As The Retail Doctor, Bob Phibbs wrote: "We are going to witness the greatest apparel clearance sale in history."
The Greatest Purchasing Opportunity
There's the saying: "In the midst of every crisis lies great opportunity." This statement holds true for off-price retailers. Although off-price retailers will face pricing pressures from the general retail market, brands cannot keep selling products at a steep discount. One reason for this is that prior to the pandemic, the retail market is already facing an industry-wide headwind, most commonly referred to as the retail apocalypse. The rise of e-commerce and independent brands have eaten a substantial portion of the retail pie, which consequently squeezed margins across all legacy brands. Below, I have included the profitability margins and days in inventory for off-price retailers, department stores, and fashion brands that are typically found in off-price retail stores. With the exception of ROST, TJX, and Nike (NKE), all other companies listed below have mid-to-low single-digit operating margins and free cash flow margins. This is an indicator that deep discounts cannot go on for lengthy periods.
(Source: MorningStar and Author's Analysis)
With large inventories and a less-than-ideal situation to sell their merchandise, the clock is ticking for the majority of department stores and fashion brands as they face potential bankruptcy. If they are not able to off-load their inventories, which I think is the most likely outcome given their high days in inventory shown above, the instinct to dash for cash might push major retailers to turn to potential buyers, namely off-price retailers. Such a scenario might result in selling inventories to off-price retailers, at or below cost. Not only that, but suppliers that had their orders canceled will have to off-load their now out-of-season products as well.
Besides having the convenience of liquidating inventories to off-price retailers, fashion brands are also wary of selling their products at a deep discount, risking permanent damage to their brand reputation. Here's BMO Capital Markets analyst Simon Siegel explaining why: "Off-price allows companies to secretly sell a lot of goods. Brands have to move merchandise but are loath to discount, on worries it will cheapen their image: Designers don’t want a quick internet search to reveal how low they’re willing to go for a sale."
These might not only give off-price retailers the greatest purchasing opportunity in a decade but also grant off-price retailers with a lot of buyer power. Instinet retail analyst Michael Baker points out that "[off-price retailers will] absolutely be in the driver’s seat in terms of the available merchandise and pick the best of the best to put in their stores." Being in the driver's seat will certainly give off-price retailers access to a myriad of well-recognized brands at bargain prices, boosting their value proposition in the process as well. Also, it does not matter if the merchandise is in-season or out-of-season, they can always store them as packaway inventory.
Outlook
As the world enters into a recession, more people will become more price-sensitive as they try to save as much money as they can, especially if government stimulus checks are discontinued or reduced. This creates an opportunity for off-price retailers to gain market share, as seen during the Great Financial Crisis where they reported year-over-year growth while peers lag behind. With a record number of unemployed persons since the Great Depression, the mass will be hungrier for bargains than ever. Unemployment might also drive people to take on creative ways to raise income. One idea that has grown in popularity is retail arbitrage — buying items in retail stores and selling them for a profit in marketplaces like eBay (EBAY) or StockX. Off-price retailers might benefit from this as their low prices offer retail arbitragers with better margins (especially if they happen to find vintage Jordans in-store).
(Source: Macrotrends and Author's Analysis)
According to S&P Global Market Intelligence, off-price retailers are expected to report worse results than department stores in Q2 this year, primarily due to store closures and the lack of online presence. However, as stores begin to reopen and guests feel more comfortable venturing out, off-price retailers are expected to outperform department stores. An added advantage that off-price retailers have is that their stores are located in off-mall shopping centers — Macy's stores are predominantly located in enclosed malls, a negative. Department store bankruptcies, such as JCPenney (JCPNQ), will also be a great opportunity for off-price retailers to snatch additional market share and cheap merchandise as well.
(Source: S&P Global Market Intelligence)
The outlook is still cloudy at this point — nobody knows how long the pandemic will last. Social distancing measures and fear of contracting the virus will discourage people from shopping in physical stores. There's also the potential of a change in customer behavior for at least the next few years. For example, for safety reasons, customers might shorten their shopping time during the pandemic, which is unfavorable for treasure hunts. Additionally, recovery in certain states will prove to be slower than others, which can be disadvantageous for off-price retailers as most of their stores are located in virus hotspots. For example, nearly 50% of ROST's stores are located in California, Texas, and Florida.
(Source: ROST Investor Presentation)
Although the near-term future looks bleak, recovery is well on the way. According to Placer.ai, TJX, ROST, and BURL stores' year-over-year traffic were down more than 95% in April, but rebounded to the -30% range in June. While comp sales are still depressingly below last year's level, the light at the end of the tunnel is closer than some might think.
Conclusion
(Source: Author's Analysis)
The three main off-price retailers should come out as winners during this crisis. For investors, ROST would be their best bet. Prior to the pandemic, the company has the highest operating margin, free cash flow margin, and ROIC. In terms of financial health, ROST also has the highest current ratio, lowest debt, and operates with the least financial leverage among the three companies. Although the company does not have e-commerce operations like TJX, the off-price model is set up to succeed without e-commerce (as discussed above). While ROST is down the most year-to-date, I do not believe it to be a value trap as ROST has the strongest fundamentals. I recommend buying ROST on a dip.
Despite pandemic-related headwinds in the near-future, ROST and peers should be able to navigate through this crisis better than department stores and traditional fashion brands. It is only a matter of time before off-price retailers benefit from the greatest close-out sale in a decade, and generate hefty profits from returning treasure hunters.
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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ROST over 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.
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