Description

PM Summary

The Container Store [TCS - $400mm mkt cap, ~$600mm TEV] is a left-for-dead (3 sell-side analysts with 2 neutrals and 1 sell), busted growth retailer ($40 at  IPO in 2013 -> $8.50 today), in the center of every major macro concern (slowing consumer, consumer shift from goods to services, COVID over-earner, supply chain challenges).  The last VIC write-up was a spot-on short call at $43 in 2013.  The shares are down 80% since then adn 50% in the last year.  I believe all of this is obscuring a company that still resonates very well with a very attractive demographic (upper-middle class, disorganized moms) and currently upgrading from D-grade management to A-grade management that is about to execute on /substantiate a number of company-specific levers that will allow them to potentially double EBITDA in the coming few years which will shift the narrative from that of an over-earning melting ice cube to a unit growth story with long runway, fueling the double whammy of estimate upside and multiple expansion off a very low base. 

Simply put, I believe there are 5 key changes/misconceptions that are being remedied at TCS that are obscured by the aforementioned ugliness:

• New CEO Satish Malhotra was previously COO of Sephora, one of the most successful retail concepts with a similar customer demographic.  He replaces two consecutive very bad CEO’s that have bungled a strong concept with poor execution.  He’s surrounded himself with a strong leadership team and now purchased shares on the open market twice in the last year.  

• TCS concept still resonates with the consumer.  Issues have been Retail 101 execution. Not easy fixes executionally, but there’s a clear playbook around store staffing, inventory management, tech infrastructure (BOPIS, digital checkout), and customer loyalty.  

• Build stores where the customers Are -> it fixes the unit economics.  Prior management built oversized stores in high-rent, high-profile cities for what seem like vanity purposes.  The customer is suburban moms.  Building higher returning, smaller stores closer to their customers will fix unit economics and reignite unit growth.   

• Launch of Store in Store partnership.  Satish led this initiative at Sephora and it was very successful and very capital efficient.  He has said point blank he will pursue that here and it makes a ton of sense.

• TCS has a best-in-class “Custom Closets” business – again, poor execution has been the hindrance and new mgmt has begun to remedy it already.  

To frame the risk-reward simply, TCS did  ~90mm of EBITDA every year from 2012 to 2019 vs an EV of $600mm today.  COVID sent EBITDA up towards ~150mm for the last two years (and produced ~120mm of FCF that has de-levered the balance sheet, permanently taking some of that risk off the table).  I believe only a couple of the above levers need to work for TCS to return to 150mm+ of EBITDA as a sustainable, growing base.  In that scenario, 9x * $150mm of EBITDA = $24 stock for a 3x+.  In the scenario where I’m wrong and the business continues to hover around $90mm of EBITDA, it’s approximately fairly valued today.  

Container Store 101 / Historical Context 

While I would refer you to the prior write-up for some of the history (which was a spot-on short thesis), I’d be remiss not to include some basics.  TCS hs 94 stores, which are is ~25k sqft in 33 states with a “carefully curated, one-of-a-kind collection of storage and organization solutions for every area of the home, at a variety of price points." Stores are organized into 14 distinct “lifestyle departments.”  TCS has ~11k SKU’s, with ~2k new SKU’s each year.  Over half of sales come from exclusive or proprietary products.  The absence of branded product reduces price transparency – difficult to match precisely with competitors and is likely the source of their best-in-class 58% gross margins.  Interestingly, TCS has ~10mm rewards members driving ~76% of revenues.  Starbucks has ~19mm and Sephora has ~17mm, but are multiples larger businesses.  TCS currently does very little with their loyalty program.  ~50% of the business is custom closets (more on this later).  

 TCS has two DC’s – one in Coppell TX (1mmsqft of warehouse space) co-located with HQ and call center and a second in Aberdeen MD (600k sqft opened in Fiscal 2019).  TCS’s top 10 vendors are ~38% of their business and 18 of their top 20 vendors have been with them for at least 10 years with several of them since inception in 1978.  ~56% of merchandise is purchased from vendors outside the US (including 21% which is Elfa in Sweden and owned by TCS as well as ~33% from China). 

TCS opened their first store in Dallas, TX in 1978.  Leonard Green acquired them for ~$755mm EV (vs today’s <$600mm) in 2007 when they had ~38 stores vs 94 today.  TCS then IPO’d with founder Kip Tindall as CEO in 2013.  After pricing at $18, the shares quickly ripped to $40.  With ~65 stores back then, the dream was to expand the footprint to 300 stores over the coming 5 years despite (50+ stores per year) despite historically opening at max 5 per year.  Unfortunately, while Kip was a great visionary (creating the concept), he was not a great operator and an even worse public company executive.  To further compound matters, his chosen successor (Melissa Reiff) was neither a visionary nor a good operator.  Years of poor execution led to margin pressures, poor SSS, and of course not opening anywhere near the planned 50 stores per year.  In fact, they have flatlined at ~90 stores since 2017.  

Importantly, our research indicates that the concept continues to resonate with an extremely broad, attractive consumer demographic.  The challenges appear to be driven by incredibly poor execution and I believe we’re nearing an inflection point that is not at all being priced into the stock.  

Key Thesis Points

Historical Mismanagement -> A+ CEO 

While TCS was founded by a visionary in Kip Tindall, his successor as CEO Melissa Reif was nothing short of a disaster.  What makes this potentially exciting is the December 2020 CEO change from Melissa Reif (a TCS lifer) to be replaced by Satish Malhotra, who was not only COO (and Chief Retail Officer) but also had a number of executive roles across technology, supply chain, store development, strategy and partnerships throughout a 20-year career at Sephora, one of the most successful retail concepts in the world.  Further, there would seem to be a considerable demographic and strategic overlap between Container Store and Sephora.  The ~first-half of this interview is a good discussion with Satish: https://www.youtube.com/watch?v=7rnW56FCbbw 

Satish purchased ~$250k of stock in May 2021 and another ~$250k last month after the recent sell-off.  While he is a little over one-year into the role, he has already begun building a strong executive team around him and importantly indicated that he sees an opportunity to double revenue and double the store count.  

Below, I’ll note a couple excerpts around prior CEO Melissa Reif’s challenges:

"And she just couldn't say no to anyone. And it just kind of grew out of control to where that store when it opened, it costs more in store payroll and operations than my North part store did. And it's going to be a fraction of the volume.”

“And so that's the thing that really kind of hampered the CEO, she was just too friendly with everyone. And she couldn't say no. And just there was a sense that no one was really held accountable. And so hopefully, he's going to be able to see that, and he doesn't have these long-standing relationships that he has to work through."

Feedback on Satish - as well as some of the key management now surrounding him has been quite positive:

“New leadership from outside the company was absolutely the best news for anyone that’s a fan of that company.”  

“From what I hear, Satish is a little bit more no nonsense.”

“Think he seems to be your good CEO. He certainly has the skins on the wall and seems to be doing all the right things. He actually has experience as a CEO, which prior leadership did not have. And he seems to be bringing in people that know what they're doing. There was a lot of upper-level leadership in place there that had been at The Container Store for 20-plus years, 25-plus years and were moved into roles just because they've been there so long.  So it sounds like experienced people that are moving into roles and they're moving faster, which is good.”

“Heard great things from general managers.  They’ve been very, very vocal that they are really excited about him”

"I think there's a lot of low-hanging fruit. I think Melissa started to kind of recognize this. I think bringing on like John Gehre, Gretchen Ganc were two incredible hires. I think one of the things that probably impacted Melissa was that people told her what she wanted to hear."  

Strong Concept….Poor Execution 

The TCS concept is quite popular among customers (76 NPS or just search for "container store" on twitter to see how many people describe it as paradise), but the basic retail 101 execution (inventory planning, staffing, store selection, unit economics) has been incredibly lacking since the IPO, resulting in what was hoped to be a 10%+ annual square footage growth story leveling off to essentially no new stores (flat at ~94) since 2018.  Customer is typically female, married with kids, >$150k HHI.  

The basic concept of TCS seems to resonate very well with customers.  The “organized lifestyle” is very much in the current wellness-centric zeitgeist, as we can see with the popularity of Marie Kondo and Home Edit shows on Netflix.  While some would argue that’s temporary, I suspect the increasing noise in day to day life from frequent digital interruptions and the infinite inventory of distractions available make this a longer-term trend.  

Container Store’s wide selection of SKU’s and amount of choice is differentiated between shopping the organization aisle(s) at Target, Walmart, or even Bed Bath & Beyond… and the product is difficult to shop for online - the nuances of 5 different organizers and how they feel/fit together and the aesthetic is something many consumers prefer to shop for in-person.  Further, there’s a significant experiential / inspirational aspect of shopping in the shores.  Often, you don’t know exactly what perfect closet or garage organizer you need off the top of your head and you certainly wouldn’t know the keywords to search for it on Amazon…but if you see 50 of them, you’ll know which one is perfect.  Many of these factors have significant parallels to cosmetics, which is where Satish’s background at Sephora appears compelling. 

While I’ll address the unit growth/unit economic challenges in the next point, the other major “Retail 101” issues the company has had are inventory planning (see below), a basically non-existent loyalty program, a disorganized labor model, and antiquated technology on both the front- and back-end.  

They’ve made changes to the labor model already and just last week launched a modern loyalty program to take advantage of the ~10mm members they had in their prior program that was going nearly untouched.  They’re also hired a new CIO, launched partnerships with Afterpay and Narvar, improved their buy-online-pick-up-in-store (“BOPIS”) program, and are rolling out more efficient mobile and online check-out processes.  The key point here is none of these are novel retail innovations - they’re basic necessities that other retailers have already proven work.  TCS has remained alive and popular despite lacking these basic necessities.  Competing on a somewhat-even executional playing field will begin to show what the concept can really be.  

“With the recent hiring of our CIO, we have put in place a robust technical roadmap to enable and support our growth plan. For example, we are actively working on technology that would allow us to ship from store, further improving upon our last three efforts and taking advantage of managing our inventory on an enterprise-wide level. We're also working on a mobile point-of-sale solution. This will allow us to dramatically improve checkout speed. We'll make our online assortment available in-store, and we'll support our even smaller store format concept.

Additionally, we are diligently working on enhancing our customer e-commerce experience through a faster site, engaging content, more relevant site searches and recommendations and additional payment options. These enhancements are on top of the improvements in fulfillment transparency through our new partnership with Narvar, which was launched in July on the heels of launching Afterpay online. Our partnership with Afterpay is already attracting new customers and delivering a higher than average ticket both in-store and online.”

“Over the past year, we've not only improved our in-store shopping experience by adding hosts, zoning key areas, and by adding demonstrations, but we've also refined our promotional cadence and messaging to our customers. In addition, we have curated our product assortment to align with customer interest and values. For example, customers have loved seeing transformations of real spaces throughout our marketing materials, which you will see in our Transform with Elfa event, the before and after graphics and testimonials shown in-store and through all digital channels of what we believe differentiate us from the rest in retail.”

Feedback from former executives echo’s the basic operational challenges the company has struggled with in the past: 

“We were unable to get products in time to get them on shelves. We're seeing kind of backlogs of product that needed to come to stores. And then we saw stores because you were waiting too long that all of a sudden, they were getting product that they couldn't fit. They were just kind of strangling themselves with product in their stock rooms that they couldn't operate to get it out onto the floor efficiently.”

One former executive gave an anecdote I thought was extremely promising – that when they got in-stock right at a store that had been open for 20-years, they saw a double-digit lift in comps:  

“And we were and that store, for a store that was open for 20 years, that last year, we were touching a double-digit growth in cross-sales. And the only thing I can say is that it was our ability to get the product that customers want into the stores.”

Improve Store Site Selection 

The most absurd part of researching the Container Store has been realizing how ….interesting their store placement choices have been.  While it’s good that most of the audience of this post have probably been in one of the Container Stores in NYC, most of TCS’s target demographic (suburban moms) don’t live in major cities.  Further, a giant store in the center of Manhattan or SF is incredibly expensive, contributing to the poor unit economics.  Thankfully, new management has realized that opening a bunch of smaller stores in the suburbs where customers are literally begging for them to open a closer store seems like a smarter usage of capital. 

The company is currently opening/testing 2 smaller stores and will likely articulate a plan to begin rolling out 100+ of these stores (vs a current base of 94) in both new and existing markets.  

“Also this quarter, we opened a new smaller format store in Annapolis, Maryland. And early results are exceeding our expectations. The customer response has been outstanding from opening day. Recently, we announced plan to open an even smaller store at 12,000 square feet in Colorado Springs, Colorado in 2022. We're excited about the demand of our stores in different markets. We not only see great growth opportunities in new markets, but also expansion opportunities in existing markets with a smaller footprint store using a hub-and-spoke model. While we are still early in the process of determining and refining our store growth plans, including a possible store within store concept, we remain focused on optimizing the productivity of our existing store base.”

“We're also excited to announce a second smaller format store in Salem, New Hampshire, which is expected to open in the spring of 2023. Our real estate team continues to develop the pipeline for additional new store opportunities, prioritizing key markets. We believe present the most attractive growth opportunities. As a reminder, we see the potential to add at least 100 new stores in the coming years, which is in addition to the potential shopping shop concept we continue to explore.”

Another executive still sees opportunity for 300 stores, but probably smaller footprints – points to one they opened in Oklahoma City with smaller footprint, outside major metro area, performing well but does see opportunity to open stores more efficiently as well to improve the economics.  

“They've also got to develop a new store opening process. I think there's a lot of things that were just very capital intensive that I think could have been curbed much more with opening new stores.” 

“I think the country could use more of them. I don't think they need to be 25,000 square feet.” 

“It was some really bad decisions. The cost of opening in downtown San Francisco, Sixth Avenue and 58th and Lexington. Those three were just bleeding money. The logistics to staff those stores was sort of the roof and the rent was astronomical.

“There was just a push to open those stores because they wanted stores in those markets. And so there was really a lot of where we want to open stores. We want to go to the flyover states and open them in suburban areas that you can get really favorable occupancy costs and salaries to staff the store is very reasonable.”

“And then those stores just print money. At that time, I think the executives really love to find to New York to open up stores and have all the fanfare that comes with that, much more than they like to fly into Champion Forest outside of Houston. There was a time where I think the executive team kind of just lost its way and they're needed to be kind of a shuffle in that area. I think that's one of the things where I know the people in kind of new store openings. I know a lot of them ended up just kind of just being frustrated and leaving because I feel like they were charged with opening certain stores and knowing that it was the wrong decision.”

“Then when it was, it kind of got put back on them. That's the only thing I can do, but I am just speculating, but I feel pretty strong that we just kind of lost our way in our focus. I think looking at the stores they have opened, they just seem to be much smarter locations just from me knowing which stores really were successful and did well as opposed to some of the ones. There's a whole lot of fun to travel there and visit, but there's not a lot of money coming back to the company from them.”

Store Within Store Opportunity

TCS has very clearly indicated they intend to pursue a partnership to launch a store-in-store concept.  This strategy was extremely successful for Sephora where Satish oversaw the initiative.  This strategy has worked for numerous retailers – Sephora with both Kohls and JCP, Target with both Apple and Ulta.  While the unit economics vary with each partnership, they are generally fairly capital-light. 

In the Kohls/Sephora partnership, Kohls recognized sales, managed and owned the inventory, provided capital and associates, and Sephora trained them.  Kohls and Sephora split the operating profits equally.  They have ~600 locations and target 850 by 2023.  The SiS’s are ~2500 square feet.  Kohl’s believes it can be a $2bn revenue opportunity. 

In Target/Ulta (starting with 100 stores, ramping to 800), the shop-in-shops are ~10% the size of a standard Ulta and Target pays a royalty on the sales while owning the inventory and reporting all sales/expenses with UIta curating the assortment and training the Target employees.  Again, Target funds the build-out and Ulta contributes a limited amount of advertising. 

While it’s all loose speculation at this point, a TCS store does ~$400/sqft.  If they open 100 SiS’s that are ~1500sqft each, with rev/sqft of ~$400, that’s an ~$60mm revenue opportunity.  It’s important to note that TCS, with it’s mix ~half proprietary, has much higher GM’s (mid-50’s) than many of its likely partners in the mid-20’s range.  I suspect the incremental margins for the combined entity would be in the 30-40% range.  Split 50-50 between TCS and the partner, every ~100 SiS could drive ~$10mm of incremental operating profits to TCS, on a base of ~$91mm of 2019 EBITDA that I use as a starting reference point.  

 Custom Closets

~50% of TCS’s business is Custom Closets.  TCS (with ~$500mm of revenue) is the leader in a highly fragmented $6bn market with a best-in-class product.  California Closets is the closest competitor with ~$300mm of revenue.  The largest part of custom closets is called Elfa, a company founded in 1948 and HQ’d in Malmo, Sweden.  TCS began selling elfa product in 1978 and acquired them in 1999 and is now the exclusive distributor in the US.  

Custom Closets drive higher ticket while differentiating TCS from other retailers selling proprietary, custom-designed closet solutions for over 42 years.  Co believes there is no other comparable retailer executing the holistic approach to custom closets.  The other two brands of Custom Closets are Avera and Laren.  TCS’s avg ticket is ~$60 but an Elfa closet is ~$600 and the more premium lines are pushing $10k.  Elfa is more of an open system without cabinet-style doors and transparent door fronts vs the premium offerings are fully veneered wooden finish and enclosed shelving and drawers.  

The feedback we’ve received again sounds like a broken record.  Very high quality product that resonates with consumers, but poor execution.  New management has quickly begun addressing the exact challenges that our research unveiled: an inefficient sales process, poor last-mile/installer integration, and lack of flexibility/vertical integration on the high end ($2k+) of the market.  They’ve acquired Closet Works, vertically integrating into premium manufacturing capability as well as installation capability and also adjusted the closet sales process to drive more specialization (IE different sales people for closets vs general merchandise).   

"I think probably why they're extremely well-positioned is just in the quality and craftsmanship of the product. Elfa has always been the leader in low cost, has some closets and shelving systems. They make the Avera line as well. We partnered with The Stow Company, which produces our Laren. And it is actually a premier solution out there, extremely well-made, the finest materials and really strong, strong customization ability.

So from a product standpoint, extremely well-positioned. It should be squashing the competition. The thing that's probably holding them back is strategy and execution to do that. And this is where I'm hoping the new CEO sees this and can direct the company differently in the future."

“I believe the Container Store is poised to just dominate Custom Closets. And I think that's probably one of the big challenges is I think that there are some things getting in the way of them really kind of being able to kind of capitalize on that. First of all, it's probably the service failures. I mean, going back to 2019, there was a lot that we're just holding together with just duct tape and our own blood, sweat and tears to kind of bring things across to the finish line.”

“They were trying to sell Custom Closets the same way they sell paper towels.” 

“I struggled with when I was there was supply chain and being able to get products to the stores and on the shelves.  I think that and the service components of Custom Closets, if they could address that, their biggest problem would be probably opening up enough stores and hiring enough people.”  

“It was so frustrating to work in a business that the product was good. Even if you had good salespeople, but the back-end process, to have to touch a customer 27, 30 times is not good.”  

“Yes. I think the big thing is just logistical issues, getting the product orders fulfilled, delivered on time without damage and misdesigns. From a store operations and a consumer point of view, it's the speed in which you can get a quote and estimate of an individualized custom solution.”

“One of the biggest frustrations from my standpoint is that once we got the ability to have a salesperson in the store with the customer design a solution, we had to send that to corporate to have someone redesign it, quote it, then send that quote back to the salesperson to then contact the customer.

And meanwhile, we've got the competition that's able to get that design and quote solution in front of the customer, and they're already selling it a day or two before we even have a price to quote. And so that was one of the big things they needed to clear up.”

“B2B wasn’t in house previously, wasn’t a big focus, brought new talent recently, will partner with builders, high rise, or senior living facility etc, starting to see contract wins..” 

“Elfa is the best product on the market, bar none and highly profitable.  The bigger challenge is in the more upscale Laren that is made to measure and has complex logistics that are harder to be managed by store associates – it’s not a smoothe process.  Sometimes multiple rounds of people coming out to see the space, design, then decide to purchase, then come back out for a professional measurement, then revisions – all before spending a single dollar…then schedule an installer to come and coordinate with delivery.  [He contrasts ] that to California Closets, which are mostly franchises, so locally incentivized by P&L, and often own the installation (something TCS is looking to in-house) and has a tool to design more easily (also something TCS is working on). ”

Risk-Reward

I believe TCS will likely introduce multi-year targets by the end of the year.  So far, they have only loosely outlined a goal of doubling revenue from ~$1bn to $2bn.  As discussed above, I use 2012-2019 EBITDA of ~$90mm as a starting point.  I believe only 1 or 2 of the above initiatives need to work to get EBITDA back towards $150mm (~2020-2021 levels) within a year years, but as a sustainable, growing base.  Retailers with healthy unit economics and a healthy growth runway (which I believe TCS will be exhibiting) of LSD comps + M-HSD unit growth trade north of 10x EBITDA.  

My bear case basically assumes nothing pans out, but the business is able to steadily tread water at 2012-2019 EBITDA levels.  In this scenario, it trades at 6x EBITDA and given the de-levered balance sheet thanks to the COVID FCF, the stock is worth ~7.50 for ~dead money/modest loss.  Some might argue 6x EBITDA is too high for a no-growth retailer - I acknowledge that.  Alternatively, I’d suggest that 4x EBITDA + ~30mm of FCF per year for 4 years gets you to a similar-ish number.  I'd again note that Leonard Green bought this company for above the current EV back in 2007 on 1/3 the store base. I do think that creates some margin of safety.

My base case assumes we get back to ~$150mm of EBITDA by 2026, but as a sustainable base rather than over-earning.  This is ~5% revenue CAGR vs 2019 and ~13% incremental margins.  In this scenario, some of the initiatives are working and the co has proven out a square footage growth algorithm.  At 9x EBITDA (I think conservative if the growth algo is on track), the shares are worth $24+ for a 3x in 3-4 years.  

My bull case assumes we CAGR revenue at 7% vs 2019 at ~15% incremental margins.  This ends up around 12% EBITDA margins, still lower than many retailers with >50% GM’s.  At 11x EBITDA, it’s a $40+ stock.  

In both the base and bull case, I’ve not accrued the interim FCF on the B/S under the assumption that a healthy amount is spent on growth.  I don’t think they need all of the FCF to fund the growth but I’ll wait to give them credit for that until we get more transparency around how much they plan to spend on the new smaller-format stores and the opening pace.  

Key Risks

As I noted in the intro, TCS sits in the cross-hairs of basically every major negative macro theme going on right now.  Unfortunately, I cannot “debunk” most of them.  Yes, the consumer spent a lot on goods for the home in 2020 and 2021 and will likely need some digest.  Yes, supply chains are a mess and not rapidly improving.  Yes, a war in Ukraine and inflation are eating into consumer confidence/purchasing power.  If you have access to high frequency data and enjoy trying to play the quarterly game, you can likely time your entry a bit better.  That said, I think the risk-reward over a 1+ year time horizon is extremely nicely skewed from here, so I try not to get too cute on the entry point.  Hats off if you can get it right. FYE 3/31/23 consensus EBITDA of 138 is growing off of the COVID-level peak fortunately, but I wish it were a bit closer to 2019 levels.  Perhaps some would want to wait for a reset in ‘23 expectations first to get involved.  

Beyond the macro concerns, to me the bigger challenge is just execution.  Satish is very impressive, but turning around a retailer is a massive uphill left in normal times.  Turning around a retailer in a historically unprecedented/complex macro environment for a first-time public co CEO is even more challenging.  There will be fits and starts along the way. 

Lastly, retail is a competitive space online and offline.  Target, BBBY, and AMZN are fierce competitors offering organization products as well and at lower margins.  I think the “category killer” concept in organization works pretty well (see above discussion in TCS 101) - it’s hard to identify exactly what is the perfect product for your needs/space without seeing/toucing/feeling it and in-person inspiration is key.  TCS has best-in-class 58% GM’s.  Over the past decade, it’s been remarkably steady, but it’s fair to wonder how sustainable that is.  

Catalyst

Concrete plans around pace of store opening and unit economics 

Store-in-store partnership announcement 

Sell-side upgrades (2 neutrals, 1 sell)

Upward earnings revisions