Why I'm Not Buying Container Store Stock

Shares of the retailer have fallen a long way since its post-IPO pop, but I see more trouble ahead.

Jul 28, 2014 at 12:52PM

The Container Store Group (NYSE:TCS) was one of the flashier IPOs on the market in the past year. Debuting at a price of $18, shares doubled in their first day of trading and peaked at $47. After two disappointing earnings reports, however, the stock has fallen down to $21 as the initial run-up seemed to be a mistake. The Container Store is not the only retail stock to follow this pattern recently, though.

Upon its debut a year ago, Noodles & Company shares quickly soared from an IPO price of $18 all the way to $49, much like Container Store. But as quarterly earnings have underwhelmed the market, the stock has dropped to $28, at a 52-week low. Potbelly also entered the markets to much fanfare, surging from an offer price of $14 a share all the way to $30, but shares have since declined steadily to $11 as its earnings reports have also been mediocre.


Source: The Container Store.

Opening new stores ain't that easy
What's driven this pattern is high expectations for the store expansion plans that the companies outlined in their S-1 filings prior to going public, as all three promised to grow their current number of locations several times over. But when margins are thin and organic sales are flat, there's little demand for new locations, and not much cash to fund them. As initial earnings reports made this distinction more apparent, all three stocks tumbled.

The Container Store currently has 66 locations, but believes there's room in the U.S. for at least 300 stores. In fiscal 2013, which ended this March, the company spent approximately $31 million on new store openings and existing store remodels, though it only made $16 million in adjusted net income. In other words, it's building new stores with money it doesn't have. It opened six new stores last year, expanding by a pace of about 10%, which may not be sustainable going forward. While adjusted net income was just $16 million, free cash flow, which deducts for capital expenditures, was only $2 million last year.

The supply side isn't the only constraint, either, as a 0.7% drop in same-store sales in its most recent quarter indicates the company may lack the brand strength to make future stores successful. Many of the stores it plans to add are in existing markets, and those could cannibalize sales from current stores, especially if organic sales are already falling.

Yeah, it's a niche market, but is it too nichey?
The Container Store bills itself as the only national retailer fully devoted to storage and organization. Bulls see that as a positive, arguing that it reflects the company's dominance of the space, but I'd say it's more a sign of how small the market is. After all, a fundamental rule of free markets is that successful businesses attract competition. That's why Whole Foods has spawned a set of smaller organic grocers, and Chipotle unintentionally launched the fast-casual restaurant industry. 

In stand-alone storage retail, the opposite has happened. In its 36-year history, the Container Store's most prominent rival has perhaps been Hold Everything, a division of Williams-Sonoma (NYSE:WSM), which had as many as 38 locations in the 1990s. In 2006, Hold Everything went out of business when the parent company closed the remaining 11 stores, folding the product line into the rest of the company, which includes brands like Pottery Barn and West Elm. 

Williams-Sonoma is no slouch in the home-retail industry. The company is worth over $6 billion, has a family of well-respected brands, puts up steady growth, and now makes over $250 million in profits. Consequently, Hold Everything's failure seems to be a result of weak industry dynamics in storage retail rather than management ineptitude.

The Container Store defines its target customer as "female, affluent, highly educated, and busy," which may be a great customer to have, but its products aren't things people really need, and as durable goods, will not drive repeat purchases. And while the company may be unique as a storage-only retailer, it's not without competition, as heavyweights such as IKEA and Amazon, among others, offer a wide selection of storage and organizational products.

Weak fundamentals
In its most recent earnings report, the Container Store had just $8.6 million in cash on its balance sheet against $332 million in debt. Goodwill and trade names make up over half of its assets. Those are intangible items that constitute no real value and are often the source of writedowns or impairments.

Sales growth is modest at less than 10% a year, which is unimpressive for a company with a P/E of over 40 based on this year's projected earnings. And with comparable sales recently turning negative, sales could slow.

Its profit margin last year was thin at just 2%, even after adjustments, and free cash flow was just $2 million.

The above figures all point to a company with a falling growth rate, poor balance sheet, weak cash generation, and little competitive advantage.

Stuck in a box
With a questionable expansion plan, a lack of a compelling product line, and an unimpressive set of fundamentals, the Container Store stock could be headed for further compression. It's a company with little competitive advantage whose weaknesses seem to overwhelm its strengths. Even after the stock has gotten chopped in half, it's still not cheap. Like Potbelly and Noodles & Co., which have continued to fall since their high-flying IPOs, I'd expect more pain ahead for The Container Store. The folks at Motley Fool's Stock Advisor may disagree, but I'm staying away from this retailer.

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John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool’s board of directors. Jeremy Bowman owns shares of Chipotle Mexican Grill. The Motley Fool recommends Amazon.com, Chipotle Mexican Grill, The Container Store Group, Whole Foods Market, and Williams-Sonoma. The Motley Fool owns shares of Amazon.com, Chipotle Mexican Grill, The Container Store Group, and Whole Foods Market. 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.

4 in 5 Americans Are Ignoring Buffett's Warning

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't 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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