February 1, 2010 was the day The Container Store (TCS +0.00%) went from a company I unfairly pre-judged to one that intrigued me.
That was the day its co-founder and CEO Kip Tindell visited us at Motley Fool headquarters and shared his philosophy for running his business. Tindell struck me as the kind of innovative, positive force I'd love to consider investing in. Privately, I dubbed him "the third Gardner Brother" -- in reference to my bosses and Motley Fool co-founders, David and Tom Gardner.
Even so, in the intervening years, I still didn't really "get" The Container Store. Perhaps because I don't fit perfectly into its primary target audience of "female, affluent, highly educated, and busy," I just couldn't understand the appeal of a store full of overpriced boxes and organizational doodads.
Then, a few months ago, I bought this wheeled storage rack:
Quite frankly, it wasn't the sturdiest thing in the world and it was slightly more expensive than I had (perhaps unreasonably) hoped, but it was pretty much exactly what I was after. It allowed me to maximize space in my "laundry closet" without having to waste a weekend constructing a clunkier, less space-efficient shelf solution:
I finally got The Container Store's appeal. When you're in de-cluttering mode, you want to go to a place that's organized about organization -- a place that can show you all the options and help you get your project done in one stop. Kind of like an organizational Home Depot.
This "aha moment" was right around the same time The Container Store went public (November 1, 2013), so I decided to invest the time to dig into its filings, financial statements, and press clippings to see if it's worth buying stock in.
For obvious reasons, it would be embarrassing if I was messy in how I presented my findings to you. I have a lot to say, so here are the boxes I put my analysis in:
- The good: 4 things I love about The Container Store
- The meh: 3 things that seem bad but don't worry me too much
- The ugly: 3 things that do worry me
- The answer: My overall conclusion and what I'm personally going to do
Let's start with the reasons I'm intrigued...
The good: 4 things I love about The Container Store
1. No real competition
Don't get me wrong. There are a lot of places that suffice in bringing order to your chaos. The Container Store lists these concepts as its primary competitors:
- Bed Bath & Beyond (BBBY +0.00%)
- Crate & Barrel
- Wal-Mart (WMT 0.54%)
- Target (TGT +1.06%)
- Amazon (AMZN +0.53%)
Add in stores like Ikea, Staples, and Home Depot, and there are many potential substitutes; however, there isn't another major retailer that's fully focused on storage and organization.
Sure, it's possible a competitor pops up to try to steal The Container Store's thunder. The Container Store has been around since 1978 and has seen clones try and fail throughout the years. Organized Living purposely avoided building stores in markets The Container Store operated in and still ended up going bankrupt in 2005. It's now an online-only concept. Formidable retailer Williams-Sonoma -- which is also behind Pottery Barn and West Elm -- tried, too. Its Hold Everything concept expanded to more than half The Container Store's current store count before ultimately shutting down in 2006.
As you'll see in my next reason, competing against The Container Store means competing against a VERY focused, committed company.
2. Long-term, holistic strategy
I hate the term "conscious capitalism."
It's a movement Kip Tindell (and The Motley Fool's founders, too) strongly supports, and it's a noble one. In simple terms, conscious capitalism looks for positive, win-win business situations rather than win-lose situations. In a conscious capitalist's mind, there's no reason employees, suppliers, customers, shareholders, and communities can't all win.
But the term "conscious capitalist" can sound a bit too hippie-ish. To some, it can connote weakness or a willingness to throw money away.
I'd prefer to say The Container Store has a long-term, holistic strategy -- its management team takes care in every aspect of its operations, building a system built to last.
You can see it in The Container Store's selection, training, and ongoing relationship with employees.
It might surprise you how hard it is to get a job at The Container Store. Harvard's undergraduate acceptance rate is around 6%; The Container Store hires less than 4% of its applicants, many of whom started out as loyal customers.
Since care is taken in the selection process, The Container Store can invest heavily in its full-time employees (note that 70% are part-time). The first year involves more than 260 hours of training (that's 6.5 full work weeks' worth!).
Because employees stick around, the training is justified. Employee turnover clocks in at 10%, vs. over 100% for the entire retail sector. That means the average full-time employee sticks around for a robust 10 years. You can imagine how that can enhance the customer experience.
Meanwhile, at the time of the IPO, the management team averaged over 17 years with the company.
That level of long-term care and partnership extends to all aspects of the company. As an example, the company picks its store sites and communities as carefully as it does its employees. It boasts of never having closed or relocated a store because of underperformance.
As you'd expect, The Container Store seeks to treat its vendors as partners, not as adversaries in a zero-sum game. On its first conference call, it was noted that at headquarters, some vendors are virtually indistinguishable from employees.
All of this points to a business aiming for decades-long relevance.
3. Big-time markups
The Container Store's markups are pretty stunning. I know it's the first thing that popped out at me when I was surveying its financials.
When The Container Store makes a dollar of sales, it only spends $0.41 on the inventory it's selling. To put that in context, look at how much less that is than its competitors (Two notes: 1) Each company may define direct costs slightly differently, but you'll get the general idea here. 2) I don't have numbers on Crate & Barrel because it's a private company.)
The Container Store can charge (and protect) this markup because it generates over half of its sales via products that are exclusive. This is a testament to the way it cultivates relationships with its vendors. In fact, it bought one of these vendors outright in the late 1990s: the European company elfa.
Say you've got an out-of-control closet or a sprawling garage. elfa allows you to design your own solution using its shelves, racks, rods, drawers, and other storage solutions. If that's too daunting, The Container Store can design and install it all for you. Here's an example of a post-elfa closet from The Container Store's website:
In Fiscal 2012, elfa sales accounted for a third of the Container Store's sales. About 40% of those elfa sales are from selling wholesale to retailers in Europe (where The Container Store doesn't compete), but wholesaling is an insignificant portion of The Container Store's growth strategy for the future.
As it expands its own store count, The Container Store wants to generate as much new sales from elfa as possible. The economics are just too compelling not to. While The Container Store generates $57 on its average customer transaction, it generates 10 times that amount on an elfa transaction. And while it generates that already impressive 59% gross margin (the flip side paying 41% for direct costs on your sales) overall, its gross margin on U.S. elfa sales is greater still -- up in the high 60s.
Gross margins of this magnitude give a company LOTS of leeway and options that margin-thin operators just don't have. And if you can operate efficiently, that can mean huge profits.
4. The growth potential
Management thinks The Container Store can grow its store count by almost 5 times in the United States.
Seems reasonable to me.
This is a snapshot of all 63 current locations:
You'll notice the amount of gray space. You'll also notice that stores are only in the U.S.
The Container Store aspires to at least 300 stores domestically. For context, Bed Bath & Beyond currently has around 1,000 U.S. stores. Put another way, Bed Bath & Beyond currently has about three times as many locations in California as The Container Store has locations in the entire United States!
Bed Bath, and Beyond arguably has broader appeal, but even so, 300 U.S. stores for The Container Store seems reasonable.
Management's guidance is to expect about 10% square footage growth per year. Using store count as an admittedly rough proxy for square footage growth, that sounds about right given that it grew 9% in fiscal 2013 (from 58 stores to 63 stores) and expects to grow 10% in fiscal 2014 (from 63 stores to 69 stores).
To add a few data points supporting this plan, The Container Store has averaged over 20% square footage growth historically (albeit from a smaller base), management says 2012 and 2013 store openings have exceeded expectations, and traditionally, it's only taken 2.5 years to recoup store opening costs on a pre-tax basis (aka a 2.5-year payback period).
Just remember that The Container Store is mum on the time frame in which it can grow from 63 stores to 300 stores. That said, if we assume that 10% rate of growth, it'll take The Container Store about 16-17 years to hit 300 stores. 2030 may seem a long way off, but a combination of 10% U.S. store count growth, the potential for international expansion (Canada's oh-so-close and you could see how its elfa operations toehold in Europe would be helpful), and same store sales growth could be quite powerful.
Speaking of those same-store sales growth possibilities, management is quick to point out it's had 14 consecutive quarters of positive comps. Note that this is during a recovering economy. Also note that its Internet sales are included in same-store sales.
From a different retailer, I might question that as a whitewash, but I think including Internet sales is smart. This goes back to its holistic thinking -- in this case, about incentives. You don't want store managers, hungry for comp growth, "encouraging" customers to buy "in store" in situations when it's easier for them to buy online. It also makes programs like its in-store pickup of online orders smoother. As we'll discuss later, adapting to an online commerce environment is important.
How does The Container Store continue to increase its same-store sales outside of Internet sales? For The Container Store, it always starts with the customer. So, of course, it's piloting a customer loyalty program in California called POP!. It's focused not so much on discounts but on "touches and hugs," as only Kip Tindell could say it. Transitioning from touches and hugs to increased hand holding, in Dallas-Fort Worth it's testing a way to serve customers better (and increase sales) with an at-home program where Container Store employees come into your home and organize everything soup to nuts.
More stores plus more sales per store is the classic growth equation in retail, and The Container Store's math checks out. Expect today's $750 million in annual sales to be dwarfed 10 years from now.
The meh: 3 things that seem bad but don't worry me too much
1. You're basically just along for the ride
Post-IPO, The Container Store remains majority-owned by the private equity firm Leonard Green & Partners, L.P. (LGP). In addition, LGP and various members of management have mutual voting agreements that further reduce any other shareholder's ability to make LGP and management do anything they don't want to do.
Add to that other technically non-shareholder-friendly things like poison pills and classification as an emerging growth company, and you basically have to be extremely comfortable that the goals of LGP and management align with yours.
As a small shareholder, you're pretty much always at the mercy of larger shareholders and management, but this is especially true of The Container Store.
On the plus side, as long as LGP has a controlling interest, we won't have to worry about distractions from the Carl Icahns and Bill Ackmans of the world.
2. The Internet Threat
Any bricks and mortar establishment these days is in danger of being Amazoned.
You could make the argument that, ironically, as The Container Store grows its own Internet sales, it's especially vulnerable.
Some of the strongest aspects of The Container Store are its highly trained, highly motivated sales floor employees and its ability to be a one-stop shop for organizational needs.
When you're online, there are, of course, no physically present humans helping you. There are also no humans offering up add-on suggestions that increase your tab. And, although the one-stop-shop aspect can still exist, it's not as big of a leap to go to a competitor's website (picture a streamlined Amazon sub site... it's not nicknamed "The Everything Store" for nothing).
For comfort, I turn again to The Container Store's holistic approach. We talked earlier about how stores are given credit for online sales. Because its management is focused and thoughtful, I'm confident The Container Store can use the Internet in conjunction with physical stores to enhance the customer experience. Of course, that's the same thing companies like Best Buy would say. Is there anything that makes The Container Store different? Perhaps. Remember that more than half of its sales are on exclusive items, so it's harder to use The Container Store as a virtual showroom, either in its physical or online locations. Also, intuitively, I think when folks are in an organizing mood, they're even more thankful for a focused, organized experience. That's true in the stores, but I think it's also true online.
These factors should allow The Container Store to stay differentiated and avoid the race-to-the-bottom price competition book sellers and electronics hawkers have been dealing with. In a similar vein, it's comforting that the average ticket is higher online than at the stores.
3. Will the Container Store work in smaller markets?
As concepts expand, a concern that usually comes up is, "Will the concept work in less perfectly suited markets?" Recall that The Container Store goes after affluent, highly educated customers. Those pockets are easier to find in 63 locations than in 300.
Management's thought of this, too. Of course, they use market research, data, and their usual care to select new markets and store sites. They also try to keep profit margins relatively consistent across their stores by adjusting the cost structure depending on the expected traffic they can expect at the store. In other words, if a new store location isn't expected to make as many sales, management keeps a tighter rein on costs.
To the underlying question of whether there's enough demand for The Container Store, I take some comfort in the experience of Whole Foods. It's a different concept, and food (even of the organic variety) is less discretionary than boxes, but they appeal to a similar crowd. As Whole Foods is nearing 400 stores in the U.S., it's recently increased its estimate of how many stores it can successfully run from 1,000 stores to 1,200 stores.
One Container Store for every four Whole Foods doesn't sound crazy to me.
The ugly: 3 things that do worry me
1. Profits: A hole in the box
We've talked a bit about The Container Store's excellent gross margins, but we haven't worked our way down the income statement yet. As we do, the picture gets less rosy.
Take a look at the graphic detailing direct and SG&A costs below:
As we saw before, when we look at the direct costs (i.e., the cost of inventory), The Container Store is in great shape, spending just $0.41 to make a dollar of sales -- way below its competitors.
But when we get to selling, general, and administrative expenses (which includes the cost of The Container Store's employees), we see the story flipped on its head. You'll notice that The Container Store spends more on these costs than it does on the actual stuff that you're buying. Compare that to Wal-Mart and Amazon, which spend about four times as much on the products as they do on the people, rent, and marketing-type costs. Even Bed Bath, and Beyond comes in at two-and-a-half times.
So, when we add together the direct costs and the SG&A costs, we see that The Container Store's direct cost advantage is largely gone. In fact, Bed Bath & Beyond actually ends up spending $0.02 less per sales dollar ($0.86 vs. $0.88).
Said another way, The Container Store is able to charge large mark-ups on its merchandise thanks to its exclusive items, its ability to cross-sell and up-sell customers, and the perceived value of what customers are getting from The Container Store experience. But much of this margin advantage is spent compensating its people.
You can see this disparity if you go onto Glassdoor and check out its full-time sales floor positions. The Container Store is routinely above $12 an hour vs. in the eights and nines for Bed Bath & Beyond, Target, and Wal-Mart.
As the Philadelphia Business Journal puts it, "Employees are paid at least 50 percent more than the average for the retail industry -- in some cases, double."
Consistent with that pay scale, when The Container Store went public, it wasn't just the C-suite and private equity folks that got paid. All employees with over two years of service got stock options (1,100 employees total). The hit for this fiscal year was $14.6 million, with $1.1 million going forward based on all options outstanding right now.
None of this would be a big issue, except that The Container Store has been unprofitable. In the trailing 12 months, it posted an $8 million loss.
There are mitigating circumstances (there always are, right?):
- The aforementioned $14.6 million stock option hit as well as other expenses related to the IPO this fiscal year.
- New store pre-opening costs of $6.8 million that hit the income statement are investments in the future, not ongoing margin dings.
- The elfa unit has had significant goodwill and intangible asset writedowns and restructuring charges over the last few years, including about $18 million worth in the last 12 months (To anticipate your next question, yes, this gave me pause, but given that the end game for the elfa unit is as a supplier to The Container Store vs. to third parties in Europe, and given that elfa sales at The Container Store are strong and growing, this is a yellow flag for me, not a red flag).
Backing all of that out, The Container Store would swing to profitability. But looking at analyst estimates for next year, profitability is still low enough that The Container Store is sporting a pricey 55 forward P/E ratio. For rough context, at today's stock price, a 55 P/E ratio would result in a profit of $27 million (vs. the $8 million loss it actually posted).
Also, as The Container Store expands, scale should allow it to expand its margins. However, two things trouble me.
First, at this point in its career cycle, Bed Bath and Beyond was quite profitable on a GAAP basis -- no backouts of one-time items necessary.
Second, with The Container Store's focus on compensating its people handsomely, I worry that people costs could largely negate the cost advantages that come with scale.
In other words, my worry is that The Container Store is a benevolent Main Street version of Goldman Sachs. As a former Goldman Sachs partner said: "I determined many years ago that if you want to make money on Wall Street, you work there; you don't invest there. They just pay themselves too well."
It's nice to see a company share the spoils with the folks doing the daily work. It's also very possible for a company to compensate its employees well AND see great returns for its shareholders (see Costco, Whole Foods, and Starbucks). You treat your employees well, they treat the customers well, customers buy lots of stuff from you, you make big profits, and everyone wins.
As a human being, I love what The Container Store is doing with its employee compensation. And I think paying a premium for premium employees can be very smart business. After all, part of the reason The Container Store can make the gross margins it does is because of the store experience created by the employees. That said, as a potential shareholder, I do worry about the possibility of The Container Store going overboard and valuing employee interests over shareholder interests -- even though the folks effectively controlling these decisions are the largest shareholders.
The metric I'll be tracking over time is SG&A costs as a percentage of sales. We saw above that The Container Store is paying about $0.47 per dollar of sales now (and, incidentally, has been paying around that for a few years). If The Container Store is scaling well and doing right by shareholders, we should see that cost come down. If not, it's a red flag.
2. Well-paid, unhappy employees?
I just got done saying that I'm worried The Container Store may go too far in the employee-friendly direction. Yet despite all of management's discussion of employee friendliness and above-market employee compensation, some of the numbers don't quite add up. Glassdoor's employee ratings paint a different picture than management's words. Check out how The Container Store rates versus its competitors:
For a retail enterprise, The Container Store doesn't do badly. Employees like the CEO (Kip Tindell), a majority would recommend the company to a friend, and overall they give it 3.2 stars out of 5. In each category, it trails Amazon and Target, but does better than Wal-Mart, Bed Bath & Beyond, and Crate & Barrel. Still, given all the talk about employees, I'd expect better than middle of the pack.
The numbers look far worse when we compare The Container Store to other customer-facing concepts that are known for treating their employees well. Look at how much it lags Costco, Starbucks, and Whole Foods by, particularly in recommending the company to a friend:
I was a bit surprised by The Container Store's ratings, but I don't want to take these numbers too far -- there's always selection bias in who takes the surveys and nuances we'll miss.
Reading through some of the reviews employees posted on Glassdoor, there were quite a few "drinking the Kool-Aid" type of comments. In other words, the employees who drink the Kool-Aid on The Container Store's philosophy love the company and are happy to go above and beyond while those who don't seem to feel it's all too much even with the extra pay. That's my very, very unscientific guess of a thought. You can take a spin for yourself here.
Bottom line for me is that the disparity between what I'd expect the employees to report and what the employees are actually reporting is a yellow flag. It's a data point I'll have in the back of my mind as I follow this company in the future.
3. The debt danger
Debt isn't always a bad idea.
Used in moderation and wisely (e.g., locking in fixed interest rates in a low-interest rate environment), debt can do wonders for a company's return on equity.
The Container Store's debt load worries me, though. It has almost $360 million in net debt, which is roughly two times its equity (that's quite high). Its EBIT (earnings before interest and taxes) covers the interest payments on that debt just 1.6 times (that's quite low).
Adding to my concern, despite being refinanced lower in November, the interest on the bulk of the debt remains at a variable rate (LIBOR + 3.25%, with a LIBOR floor of 1.00%). Let me translate that. LIBOR is currently below 1%, so The Container Store has a little wiggle room before any interest rate rises would affect it. But after that, every 1 percentage point rise in interest rates would increase The Container Store's interest payments in the neighborhood of $3 million-$4 million per year, making it that much harder to be meaningfully profitable.
Given the size of its debt load combined with existing covenants on that debt, if interest rates rise or economic conditions worsen, it could be difficult to add more debt beyond its current agreements.
Many a good business has run out of time at the hands of too much debt. My hope is that The Container Store can outgrow or pay down its debt before that happens.
My overall conclusion, and what I'm personally going to do
I am quite torn on The Container Store. I love the idea of getting in early on a focused, holistically thinking company that has the potential to dominate a well-defined niche. The care management takes with each aspect of the business is wonderful. Meanwhile, the monster gross margins can make up for many sins and errors.
That said, we're dealing with a company that has yet to show consistent profitability. That can be cured with scale, but if management and Leonard Green & Partners want to run The Container Store more for the benefit of employees than for the benefit of shareholders (of which they're the largest), there's not much we as minority shareholders can do about it. And The Container Store's massive debt load risks us never seeing The Container Store's promised scale.
The current stock price in the low $30s means we're paying a market cap of around $1.5 billion to $1.6 billion for the promise of The Container Store's future. That translates into paying about two times sales. That's pricey for the retail sector (Bed Bath and Beyond goes for 1.2 times sales) -- at these prices, a good deal of growth and steady-state profitability are baked in.
Still, I like The Container Store's potential enough, and the price is reasonable enough, that I want to buy an initial position. In the coming days, I'll be buying a small number of shares of it in the real-money portfolio I manage for The Motley Fool. Afterwards, I will also be buying a bit personally when our trading rules allow me to do so.
Given its status as a young, newly public company with a large debt load, The Container Store's stock may be volatile, and we could see much lower prices than today's share prices.
Honestly, I kinda hope that happens. If we do see better buying prices, I may not be able to contain myself.
