TJX Companies, Off-Price Retailer With Apple-Like Profitability

With consumer spending accounting for about two-thirds of GDP, it’s hard to ignore retailing stocks. Still, given the ups and downs of consumer tastes, sentiment and spending prowess, as well increasing competition both physical and cyber, it always seems easy for worry-warts to scorn this group. The key, here, ultimately, is to invest not simply in retailing but the right retailing and TJX Companies (TJX) seems a good way to do just that.

Of Factors and Themes

As readers familiar with my approach know, I’m not a story- or theme-investor per se, as reiterated by my writeup last week of a solar energy stock. So I’m not really interested in TJX because I specifically want retail. I pointed out the importance of this sector to establish why, unlike many theme-based investors, I’m not going out of my way to exclude it.

I choose stocks on the basis of factors, or objective quantitative fundamental-analysis based rules. Off-price (mainly apparel) retailer TJX came to my attention, and into my portfolio, through a model seeking lower-risk equity exposure. That approach hasn’t necessarily rewarded investors up till now as the Fed continued to pump out money like there’s no tomorrow. But risk may move center stage as and when the Fed finally feels a need to control the spigot or turn it the other way.

Quest For Lower Risk

As soon as we say the R-word, we feel a need to access our inner quants as we contemplate such jargon as standard deviation, volatility, Beta, etc. Beta is an especially revered item in this area. For what it’s worth, TJX shines in this regard with a Beta of 0.58 (meaning its stock return is only 58% as volatile as that of the S&P 500, versus an industry median of 1.10 (implying 10% more volatility than the market).

I’m not, however, going to stop here. Actually, Beta is, to borrow a phrase from U.S. Supreme Court Justice Antonin Scalia, “jiggery-pokery.” It can be a good answer, but often it’s for the wrong question. Beta only measures the path of a stock relative to the path of the S&P 500. This refers to the past, obviously, since we don’t have data from the future. Beta gives no consideration whatsoever to anything that could justify an assumption that the future path will in any way resemble the past. My bullishness on TJX is based on its execution of a business model that seems built for low risk, as reflected in relevant quantitative measures and confirmed by qualitative consideration of how it does business. My Smart Alpha Low Volatility Select – SP 500 model on Portfolio123 aims to find such stocks based on fundamentals I believe likely to result in lower volatility in the future.

On Target With Off-Price

We know what off-price retailing is. It’s about getting good brand-name merchandise at deeply discounted prices. This doesn’t happen because some retailers are greedy and others aren’t. Think of this phenomenon as being necessary to keep the retail channels flowing smoothly; to unload goods that result from manufacturer overruns, closeouts (i.e. product left over after a style is being discontinued), etc. If we didn’t have off-price retailing, we’d suffer from frequent shortages, periodic production shutdowns to clear excess inventory, and/or having current styles sold next to deeply discounted products from the last cycle (a good way to tarnish a brand). Think of off-price retailing as analogous to what market makers do when they provide liquidity in the stock market. They balance out supply and demand and keep things going, to the benefit of everybody. So while there may once have been a time when some might have seen off-price retailing as trashy, forget about that. This is an important part of retailing that’s here to stay.

To make this work from the customer’s point of view, a merchant can’t rely on good prices alone to do it. Store A has good prices. So, too, do all its rivals. What’s needed is an enticing line of products. Customers need to believe that if they go to TJ Maxx (this firm’s flagship chain), or wherever, they won’t always see wearable garbage on display, but legitimate items, things they’d really be happy to wear. It’s a treasure hunt. Customers don’t know what they’ll find; they understand that’s not what off-price is about. But they need to believe whatever they find will more often than not include things of interest to them. And they can keep coming back frequently. TJX’s lean inventories (trailing 12 month inventory turnover: 5.62 versus 3.81 industry median) keeps assortment fresh.

That’s hard for a retailer to deliver on. They are at the mercy of what goods are put into the off-price channel. But with TJX, we’re at least taking about a big-gorilla. With access to 17,000 vendors, it stands a terrific chance of being able to find things it believes its customers (many being teens and 20-somethings) will want. And it can get what it wants and do so at good prices because unlike many rivals, financially strong TJX can and does pay promptly without having to bargain for fancy terms (such as return privileges, advertising contributions, etc.), can and does take incomplete assortments, and because suppliers know this retailer, with its massive-sized 3,000-plus store chain with sophisticated distribution system, will be able to smoothly and efficiently clear the goods.

It’s not easy to do what TJX does. Size obviously helps. So, too, do smarts, which we find in its cost-efficient operations, flexible formatting (partition-free stores can give departments as much or as little space as warranted by what’s available without having to keep changing the store around), and the company’s proprietary inventory management system that coordinates store needs with local tastes.

Apple-Like Numbers

TJX’s Comparable-store sales gains were strong in the last quarter. But I’m not interested in TJX based on momentum. Every retailer has ups and downs. I care about the big picture, that which is likely to be sustainable. Table 1 has the numbers that impress me:

Table 1

TJX’s gross margins are a bit below industry norms, but as a deep discounter, that’s to be expected. What’s interesting is that TJX has above-par operating margins. That factors in a lot of overhead, and confirms the company’s reputation as being a very efficient outfit.

And how about those returns on assets and equity! These numbers put TJX, an off-price apparel merchant, on par with the great innovation brand master, Apple (AAPL). The latter’s 12 month and 5-year returns on assets were 20.45% and 22.68%, while its returns on equity were 46.25% and 39.00%. Like Apple, TJX is buying back stock.

In business school, they teach that returns this high can’t be sustainable given the likelihood they’ll attract rivals who’ll compete for market share the result being lower returns for all players. But sometimes, taking market share is easier said than done, or at least easier said than done profitably. There are indeed, competitors, to both AAPL and TJX. We understand the unique attributes that enable AAPL to keep charging high prices, because we see them and because many of us are choosing to continue paying them. With TJX, it’s not so easy for us, as corporate outsiders and in many cases, non-customers, to see its special characteristics; its scale, its inventory system, and its operational methods. The numbers, though, suggest they’re just as real. (This is an interesting benefit of factor-based investing: How else can one write about TJX and AAPL in the same post!)

Companies with returns like these tend to produce more stability in their income streams and that (a topic for another day), rather than historical price-based metrics like beta or standard deviation, give rise to expectations of modest risk in the future.

Paying For Quality

If you want to reduce risk in the stock market, you have to be prepared to pay for that, contrary to what some (who assume lower PE ratios expose them to less risk) may believe. Valuation models, including the cornerstone Dividend Discount Model include, in the denominators of fractions, terms for cost of equity or required rate of return. However one expresses it, this term drops in magnitude as risk recedes meaning the fair price, relative to earnings, sales, etc., is pushed upward.

So not surprisingly, TJX stock is a lot pricier than the merchandise it sells in its stores.

Table 2

This is a place where TJX and AAPL sort-of part company. The latter is similarly expensive in when valued based on sales (2.88 versus 1.11 industry median) and book value (5.63 versus 1.86), as should be the case based on high margins and returns on equity. But AAPL is less pricey when price is compared to trailing 12 month EPS (12.86 versus 19.32) and free cash flow (11.50 versus 17.28).

The differences, here, involve the other major factor in valuation, growth expectations.

Oddly, going by the book (the formally published consensus data), analysts expect more growth from AAPL, a 13.93% long-term EPS growth rate, compared to 10.94% for TJX. And in both instances, company projections fall shy of industry median expectations (13.44% for TJX’s peer group and 15.67% for that of AAPL). The differences in earnings- and cash flow-based valuations are telling us Mr. Market believes in the lesser growth projections for AAPL but is dismissing them for TJX.

So we’re called upon to choose: Do we agree with Mr. Analyst or Mr. Market? With AAPL, the market is apparently concerned about the sustainability of its super stature as competitors continue to fire volley after volley. But that’s not my focus today, so I won’t express an opinion on which view seems most reasonable.

As to TJX, I’m voting with Mr. Market. I don’t know that any of the numbers is necessarily correct – these are, after all, “long-term” projections so precision is not the order of the day. That said, I do think TJX can outgrow its peers.

Non-glamorous business models don’t usually inspire buoyant analyst expectations. But that, actually, is the point. Expectations for TJX don’t depend on any particular fad, trend or style choice being correctly assessed and being sustainable over a number of years. Fashion is horribly fickle, and back when I covered retail stocks regularly, I typically found it best to bet against earnings surprises, guidance increases, etc. Mr. Analyst loves to extrapolate; to assume the recent past will persist forever. Fashion tends to deliver the opposite.

I’d much rather take a stand on a business model that regularly puts high-grade merchandise (whoever is designing it and whatever the style) at bargain prices in a treasure-hunt atmosphere (credit card burdens may inhibit old-style shop-till-you-drop, but what TJX offers, adventure on the cheap, is a nice substitute) from a company that has mastered the art of efficient operation. The latter consideration is another interesting difference viz. Apple’s high margins and returns are at the mercy of customer tastes. Margin and return sustainability at TJX depends on something management can control, its own ability to continue to execute.

Adding support to favorable expectations regarding TJX are the company’s expansion efforts that include international expansion (TJX Europe, TJX Canada), applying its capabilities beyond apparel (Homegoods, the leading domestic off-price retailer of home fashions such as lamps, rugs, wall décor, accent furniture and on line (i.e. Sierra Trading Post the leading off-price internet seller of outdoor gear, sporting goods, family apparel and shoes, and home fashions that TJX acquired in 2012).