US consumers are really feeling the pinch from higher inflation. Spending power has declined and households across the income spectrum have had to cut back on certain luxuries, as they refocus their budgets on necessities. This has created a challenging backdrop for most discretionary retailers. While many companies, such as the dollar stores, have provided commentary on challenges faced by their core consumers, we’ve seen other companies emphasise how they are winning share as consumers seek value. One category of retailers that has performed well against this value-seeking narrative is the off-price channel.
What are off-price retailers?
Off-price retailers, or discount retailers, sell branded apparel and other merchandise at a discount. Their inventory is generally made up of discontinued items, surplus stock or merchandise with slight defects. They serve as an important distribution for brands with scale to sell their discounted goods. Consumers benefit from access to well-loved, high-quality brands at a more affordable price. Goods in their stores are usually available in limited quantities. This creates a “bargain-hunting” experience for shoppers as each trip is a unique opportunity to uncover new items.
The largest players in the industry are The TJX Companies or “TJX” (market cap US$132bn) and Ross Stores or “Ross” (market cap US$50bn). Both companies have significant scale and superior merchandising capabilities which give them an edge in offering unique stock at an attractive price point.
Off-price retailers are unique retailers as they can outperform in both strong and weak economic environments. In stronger economic periods, they benefit from a general increase in consumer spending. In more challenging economic periods, they benefit from high and middle-income consumers trading down as they seek bargains and can no longer afford as many fully priced branded items. Since the start of interest rate hikes in 2022, we’ve seen a meaningful outperformance from both companies, driven by both multiple expansion and earnings growth.
Why have they performed so well?
The period from March 2022 has a few unique drivers that made off-price retail an attractive investment to us during this period:
- Optimal buying conditions: Lockdowns caused significant logistical delays, leading many retailers to overstock and have too much inventory on hand. Off-price retailers could thus have their pick of attractive merchandise at reasonable pricing levels.
- Reopening created demand for unique in-person shopping experiences: This model is better suited to brick and mortar vs ecommerce, given the unique nature of the inventory (limited quantities of individual items, etc.). While many consumer-related sectors grew by increasing prices, off-price retailers have managed to grow by increasing volumes as foot traffic accelerates.
- Lower freight costs as supply chains normalised: This supported profitability which already benefitted from improved merchandise margins from the attractive buying environment.
- Gained market share from department stores, which remain under pressure: Department stores such as Macey’s have been losing market share as consumers seek more value. Off price retailers have grown at double the rate of the broader US apparel and footwear sector over the last decade.
- Weak real estate market created affordable expansion opportunities: Their stores are located in outlying shopping centres, and they have benefitted from other retailers (such as Bed, Bath and Beyond) entering bankruptcy and closing stores.
- High quality, defensive model: Both Ross and TJX have incredible store economics with payback periods of less than 2 years and with IRRs in excess of 55%. This supports a return on invested capital in the mid-20% for each retailer and increasing as profitability expands and efficiency continues to improve.
What is the outlook for the industry?
Off-price retailers are benefitting from key secular trends that have supported their outperformance, such as the decline in department store market share and an increased emphasis on value by middle and higher-income consumers. These retailers are long-term, high-quality compounders and they are likely to continue to grow earnings at a rate of at least 10%, even as the US economy slows down.
The share prices of both companies have benefitted from their more defensive status, with valuations having rerated over the last few years to more accurately reflect this “defensive premium”. Current pricing levels are not an ideal entry point, but we believe that these companies should be a core holding in a long-term portfolio which can outperform during parts of the cycle.