The Container Store's 3 Key Weaknesses

The Container Store recently went public to much fanfare as a darling of Wall Street, but there are three major weaknesses the company has that investors need to be aware of.

Jan 15, 2014 at 12:34PM

Last year, one of the top IPOs to hit the market was The Container Store Group (NYSE:TCS). Since then, The Container Store's stock has risen 137% on hopes that the company will continue to build upon its brand as a specialized organization products retailer. The company's storage products, knowledgeable associates, and customized closet systems boast loyal customers that love what The Container Store has to offer.

However, any Foolish investor looking to place a bet on this specialty retailer's future must be aware of all the facts, including the company's weaknesses. No business is perfect, and while The Container Store has multiple strengths, it also possesses some key flaws that could very well prove to be the difference between making the company a winning or losing investment for years to come.

Operating in a niche market
As investors can imagine, The Container Store caters to a very limited target market, as it is the only retailer that only offers organization and storage solutions. Typically, shoppers of The Container Store are high-end consumers who have the means to spend more on home and office organization. 

These high-end consumers make up the majority of The Container Store's sales because they are willing to pay 10% to 15% more for containers that they could buy at Wal-Mart Stores (NYSE:WMT) or Target (NYSE:TGT), as well as being able to afford higher-quality shelving and storage systems.

Middle- and lower-income households, however, are not willing to pay more for organization products that they can purchase at Wal-Mart or Target for a cheaper price, even if the quality is better. Plus, while at Wal-Mart or Target customers can shop for food, toiletries, apparel, electronics, bedroom accessories, and more, which they can't do at The Container Store.

As you may know, Wal-Mart became the world's largest retailer by operating SuperCenters, massive discount stores where customers can do all of their shopping in one place. This scale has allowed the company to generally price its products for cheaper than other retailers -- after all, it has the advantage of buying in bulk. This advantage is one of the primary reasons that retailers like Wal-Mart and Target will be around for years to come.

Great culture but lack of profitability
The Container Store's extremely knowledgeable associates and store environment are reasons why customers choose to shop there for organization supplies over Wal-Mart and Target. The Container Store's employees offer expert advice and excellent service that customers are unlikely to receive at big-box retailers.

Unfortunately, The Container Store has not found a way to translate its great customer service to its bottom line. Its gross margin for fiscal year ended March 2013 was 58.8%, whereas rival Bed Bath & Beyond (NASDAQ:BBBY), which provides a wide selection of home goods, had a gross profit margin of 40.8% for the same period. This may sound like good news for The Container Store, as it means the retailer has been able to charge a premium for its products when compared to Bed Bath & Beyond. However, this advantage is gobbled up and then some by its selling, general, and administrative expenses.

As a percentage of revenue during fiscal year ended March 2013, The Container Store had 46.9% of its revenue consumed by selling and wage expenses. This compares with Bed Bath & Beyond, which only registered SG&A expenses at 25.2% of revenue. This difference is staggering, especially when the investor combines The Container Store's SG&A expenses with the company's cost of goods sold. This leaves just 11.9% of revenue for all other expenses associated with company operations, including interest on debt and depreciation of asset charges.

No wonder The Container Store showed a net loss attributable to common shareholders of $90.5 million for the fiscal year ended March 2, 2013, while Bed Bath & Beyond, ignoring the fact that it is a much larger retailer, had net income for the same time period of $1 billion. Clearly The Container Store hasn't quite figured out how to turn its revenue into rewards for shareholders.

Low barriers to entry
As with most retailers, there is nothing preventing a competitor from opening a store extremely similar to The Container Store under a different name. In addition, as loyal as The Container Store's customers are, the company does not have a monopoly on organization supplies. Customers can go elsewhere for plastic bins or other organization supplies. This compares with Apple's Apple Store or Michael Kors Holdings, both of which sell products the public wants.

In both cases, if you want to buy an Apple product or Michael Kors bag, you must find your way to the companies' products. The Container Store, in contrast, does not hold as strong of a position within the marketplace, which can be changed by making its brand name much stronger. In time, when consumers think "organization," they will think "The Container Store" before any other retailer.

Foolish takeaway
The Container Store is one of the most unique retailers out there -- catering to those consumers who are serious about buying high-quality products to organize their homes. There is certainly a market for this, as evidenced in the company's continual growth. Thanks to the company's IPO last winter, Foolish investors now have the ability to become shareholders in this one-of-a-kind retailer.

However, the company has several important weaknesses in its business model that all investors need to be aware of before making an investment. These weaknesses don't make the company a bad investment, necessarily; it just means that Foolish investors should do more research to assess whether or not the company is right for them.

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Fool contributor Natalie O'Reilly has no position in any stocks mentioned. The Motley Fool recommends Bed Bath & Beyond, Michael Kors Holdings, and The Container Store Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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