The announcement earlier this month that Daffy's, a New York-based off-price retailer, was shutting down feels like a bad omen for the off-price shopping segment, following Syms' bankruptcy and shutdown of Filene's Basement last holiday. But should the segment leader -- TJX Cos. (NYSE: TJX ) , the parent of Marshalls, T.J. Maxx, and HomeGoods -- be worried? Yes and no. It's a solid company, but the macro environment is turning into a more awkward fit.
Shoppers are closing their wallets, as witnessed when Daffy's cited the uncertain economy and weak consumer spending among its reasons to close down. Conventional wisdom is that if we double-dip, shoppers will turn away from department stores and dive back into the off-price racks. But that's a lesson Nordstrom (NYSE: JWN ) , Saks (NYSE: SKS ) , and others learned well the last time around. They're not going to let TJX and rival Ross Stores (Nasdaq: ROST ) eat their lunch again in a recession.
It's a similar dynamic to what we've noticed before about dollar stores -- their competitors are learning their tricks to bring in the 99%. So the days of throwing open the outlet doors and watching cash-strapped shoppers flood in are coming to an end. For TJX and Ross, the double-digit sales growth will be much harder to come by going forward.
The management of Saks noticed that its discount-oriented Off Fifth was its saving grace early on in the recession, just as Nordstrom focused on how the Rack chain continued to grow sales while its mainline stores struggled. Macy's (NYSE: M ) only began experimenting with Bloomingdale's outlets in 2010 and has only seven locations now, but it's told analysts there's potential for up to five openings a year through 2014. And Citi has estimated Nordstrom doubled the number of Rack stores since 2008.
That's going to put a cork on the upside off-price stores will get from another round of recessionary shopping habits. And it's going to dull their fashion edge; TJX depends on strong relationships with designer brands such as Polo Ralph Lauren. It won't be easy to stock up if it has to compete with Saks, Nordstrom, and Bloomingdale's outlets for that inventory.
Contrary to popular belief, the department-store outlets don't sell only the leftovers of the full-price stores -- that's only a small portion of what's on their racks. Most is inventory purchased expressly for the off-price stores. Citi estimates that only about 20% of the inventory at Nordstrom Rack and 10% of Saks Off Fifth inventory comes from the full-line stores.
And those outlets will be competing against their own suppliers. A recent Citi report estimated the outlet channel racks up $30 billion in sales a year, and noted manufacturers are trying to work out their own strategies for that channel, too. Citi retail analyst Deborah Weinswig said that a number of apparel companies including True Religion and Under Armour are expanding their own outlets, while others including Hanesbrands and Finish Line are focusing on holding the line on off-price selling through better inventory management.
So the off-price specialists like TJX and Ross will find themselves bidding against department stores for a shrinking supply of jeans and dresses. That would favor the leaders in the outlet segment; as Morningstar has noted, TJX has deep relationships with suppliers that some of its rivals don't have. Inventory flow is the reason Morningstar rates Ross higher than TJX (three stars, instead of two); it tries to stock a small supply of a wide variety of items, instead of a variety of sizes on each item, so it can afford to price things right, according to Morningstar's analysis. And TJX is also depending heavily on international expansion, with new openings in Europe, which are tricky, given the fiscal crisis in the continent.
TJX gets a four-star CAPS ratings from Fools, and for good reason: It hasn't missed expectations in memory, net sales are growing at double-digits, and management recently raised second-quarter estimates. But as Zacks noted recently in remaining neutral on the stock, TJX faces rising input costs that will hurt margins. And the international expansion is not providing a cushion.
The stock is such a favorite that it's trading uncomfortably near its $46 consensus target. Big long-term upside is about to become less of a sure thing. Hold onto it if you have it, since it is the sector leader and there is strength in numbers in the discount market.
Ross, which is a smaller competitor, is also a healthy company, with a four-star CAPS rating. As we've noted here before, it's racking up impressive sales gains this year. But as Fool Dan Caplinger noted recently, a 70% gain in shares over the last year and a P/E of almost 22 have made it a less attractive valuation.
So hang onto your off-price retailers, if you have them, but tread carefully going forward. If you'd rather invest in a different kind of retail growth story, check out The Motley Fool's Top Stock for 2012, a big-box retailer that's mining emerging markets. Get your free report by clicking here.