TCS - The Container Store: High Returns Possible For Investors Willing To Deal With Volatility

2023-09-25 23:29:04 ET

Summary

• The Container Store is facing both short-term and long-term concerns.
• I think bankruptcy risks are low, which provides some downside protection at the stock’s current price.
• Over the next 12-24 months, I think TCS stock could trade between $5 and $9.50 in a bull case and at $1.40 in a bear case.
• I’ll discuss the reasoning behind these price targets and provide an overview of the business and its past financial results.

Industry supply/demand dynamics and company specific issues are putting The Container Store Group, Inc. ( TCS ) in a difficult spot. Consumers have pulled back spending on goods while other retailers are overstocked on inventory to meet demand that they thought would continue into this year. This has created a heavily promotional environment that has led to a large reduction in sales and margins for many retailers, including The Container Store.

Specific to The Container Store, the company must thread a needle in order to put itself in a position for long-term success. It must first navigate its debt burden and interest expenses, and it must also invest somewhat aggressively for the future given the competitive pressures from other organization stores and large online retailers. There are real terminal value concerns with The Container Store and it must continue to invest in technology, stores and products if it wants to succeed in the long term.

These industry and business-specific issues have led to poor financial results over the last year which have caused a large decline in The Container Store's stock. Most retailer stocks have fallen greatly since 2021 but not many have fallen 90% like The Container Store's has. This drop is requisite to the drop in the company's earnings and the market's concern over the company's debt.

This 90% decline is bad for current shareholders but it creates a high reward opportunity for new investors. If the management team is able to invest intelligently and if consumer spending trends reverse course, The Container Store should provide massive returns as bankruptcy concerns ease and earnings power normalizes to previous levels. If same-store sales stabilize and EBITDA returns to the $80 million range that was seen prior to the pandemic, the stock has the potential for 300-400% upside over the next 2 years.

This type of return comes with high risk. Party City was in a similar situation before they filed for Chapter 11 bankruptcy early this year. The turnaround potential looked similarly appealing but the company decided not to continue fighting for the turnaround and went with a decision that may be better for the business long-term despite wiping out equity holders.

I think there is less of a chance that The Container Store will file for bankruptcy, but if current trends with consumer demand and rates continue for a long period of time, they may have no choice. In this report, I'll discuss both scenarios, why I think the stock may be worth a small position depending on the investor's risk tolerance, and I'll provide an overview of the business and its past financial results.

Business Overview

The Container Store breaks its business down into two segments: The Container Store and Elfa. The Container Store segment is the main business that houses sales from 97 company-operated stores and its online DTC sales. In FY2022, this segment had $991 million in sales and comprised 95% of the company's sales. This segment also contains Closet Works, which was recently acquired for about $20 million .

The company made this acquisition in order to help reach the long-term goal of $2 billion in revenue as it will further expand the company's reach into the custom-closet market. This deal closed in early 2022 and was likely in the works when demand for these types of products was at its peak in 2021. It may provide good synergies over time but it was a poorly timed acquisition.

The Elfa segment houses the Elfa brand, which was acquired by the company in 1999. Elfa designs and manufactures component-based shelving, drawer systems, and custom sliding doors. The Container Store segment is the exclusive distributor of Elfa branded products in the U.S. but Elfa products are sold to wholesalers internationally.

Anecdotally, the people I know who shop at The Container Store really love the store and purchase its products often. This aligns with the fact that the loyalty program has accounted for 80% of sales since its launch in 2022. Loyalty members also spend 57% more than non-loyalty members.

Past Financial Results

The Container Store is a specialized retailer but it sells commoditized products and the company's returns on invested capital reflect this.

The company operates in a very competitive industry despite the fact that there aren't many other publicly traded comps. Competition comes from large retailers such as Amazon and Ikea, and from small local and regional stores. The Container Store is a recognizable brand but its returns on invested capital reflect that it is the marginal supplier of a commodity product in a competitive industry. The company's ROIC will continue to rise and fall with the industry tide.

The company's store count has gradually risen over time from 61 in 2013 to 97 today. In that same time, revenue has grown from $706 million to $991 million in the trailing twelve-month period so revenue growth has not grown in proportion to the growth in store count. This indicates that the company has not been able to gain market share with consistent growth in same-store sales.

Additionally, margins have not expanded as sales have grown. Of course there has been some noise with the odd consumer demand environment over the past few years, but the trends over time all point to the fact that The Container Store is not a competitively advantaged business. The business has not changed significantly enough recently to make me confident that these past trends won't continue into the future. The Container Store investors should have some sort of opinion on the trends of the retail industry and macroeconomic environment because of this.

Capital expenditures have been declining in absolute terms since 2013 but have been on the rise recently as the company's new CEO is more committed to growth investing than the previous management team. These investments have been in the form of store count growth, acquisitions, and technology. While these investments may be a hard-to-swallow pill for investors who want debt paid off, I think they are important for the company to stay relevant in the future. The difficulty comes in striking the balance between investing for the future and keeping the company afloat in the short term.

Bull and Bear Case

At the moment, The Container Store's stock offers high rewards with high risk. Additionally, it is a very volatile stock given its market cap and low volume of shares traded per day. I think the stock could be worth a small position in certain portfolios because bankruptcy seems unlikely which will limit the stock's downside to an extent. However, if industry and consumer trends continue as they have been over the past year, the company's earnings will continue to drop leaving little valuation floor for the stock.

However, if these trends reverse and there is a reversion to pre-pandemic earnings power, The Container Store's stock has significant upside. It doesn't take a complex model or intricate calculations to see this.

For example, if FY2025 EBITDA is $70 million, a conservative 6x multiple leads to a $5 price target assuming $170 million of net debt and 49.5 million fully diluted shares outstanding. At a more extreme end, if FY2025 EBITDA is $80 million, an 8x multiple leads to a $9.50 price target when keeping debt and share count assumptions the same.

On the other hand, Q1 2024 EBITDA was around $3 million. I don't expect this level of earnings to continue into 2025 but if FY2025 EBITDA is $40 million, a 6x multiple leads to a $1.40 price target assuming $170 million of net debt and 49.5 million fully diluted shares outstanding. Bankruptcy would wipe equity holders out but I don't think this is a likely situation.

Some may point to Party City's recent bankruptcy as an analogous situation, but I think there are some key differences. First, Party City had a business that was more susceptible to terminal value issues and threats from online retailers. For the sake of Party City's employees and customers, the best path forward was to wipe out as much debt as possible which would allow the company to continue operating for a longer period of time before online retailers lead the business to irrelevancy.

Second, Party City's board and executives weren't significant owners of the company's equity. This means that bankruptcy proceedings that wiped out equity holders did not sting their pockets as much as they would The Container Store's board and executives.

The Container Store's board includes members who own 60% of the total equity through various funds, and the company's executives have recently been buying shares on the open market. They will likely fight hard to make sure these ownership claims don't become worthless.

The CEO, Satish Malhotra, also recently agreed to take a 10% salary reduction . This, along with recent open market purchases of shares, are indicative of an executive team that will fight to avoid bankruptcy and care about brand equity.

Interest expenses aren't too much of a burden for the business either. Management is guiding for $20 million of interest expenses in FY2024 which will likely consume all of the company's operating income for the year. However, the company has operated with inventories equal to 10% of revenue in the past compared to 19% currently. If there is a cash crunch they will be able to liquidate inventory closer to 10% of revenue, freeing up $90 million of cash. This will hurt growth aspirations and competitive positioning in the industry but will keep the company and shareholders afloat.

Final Thoughts

I see a price target range of $5 to $9.50 for the bull case and a price target of $1.40 for the bear case. These price targets are for the next 12-24 months but the stock will be very volatile in the period before that with retail spending data, interest rate changes, and quarterly results. Given the range of price targets and my thoughts on the company's bankruptcy risk, I think the stock could be a good small, speculative position in certain portfolios.

I don't think The Container Store or the organization industry is a long-term winner in the retail space so I would not hold the stock for a long period of time. The Street is mainly focused on what the company will earn over the next few quarters and the company's results relative to the Street's expectations will drive the stock over the next 12-24 months. Given the low expectations for the retail industry, a bet against these expectations can provide high returns. However expectations are low for a reason and if current consumer demand trends continue as they have been, the stock will continue to fall with earnings.

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