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America's virtually instant transformation into a lazaretto will undo longstanding comparable sales growth streaks for off-price retailers in 2020, but the long-term factors underlying their narrow economic moats and ability to transcend their full-price counterparts' more chronic woes remain in place. Also, we think strengthened balance sheets should provide ample ammunition for combating short-term turmoil. The near term is not without challenges; while a difficult-to-digitize business model protects TJX TJX, Ross ROST, and Burlington BURL long term, their limited e-commerce options are a liability at present. We think shoppers are likely to stay wary about lingering in stores for extended periods on a bargain hunt, particularly if social distancing efforts continue to limit work and social opportunities outside the home.
The speed of the recovery influences valuation, with up to a midteens negative percentage impact in the more pessimistic scenarios we analyze. However, long-term investors should focus on the sector's capacity to capture low-single-digit comparable growth with significant store footprint expansion once the pandemic fully recedes. Ross is the best positioned of the three off-price retailers we cover, with a conservative operational and balance sheet approach, and TJX is not far behind. Burlington's turnaround injects some potential for volatility. We see their valuations as fair and suggest investors await more attractive entry points that may emerge as a volatile 2020 unfolds. We think investors favoring retail should instead consider no-moat Kohl's KSS or narrow-moat Nordstrom JWN.
Near-Term Pressure Considerable, but Liquidity Seems Sufficient
With stores shuttered in late March in response to the COVID-19 outbreak, off-price retailers--like many others in retail--are facing an unprecedented period of little to no revenue with only limited relief from fixed costs. And we do not anticipate reopening will happen just by throwing a switch; store cleaning and sanitization requirements will rise, furloughed employees will have to be brought back en masse, spring assortments will need to quickly be transitioned to summer, and the chains will probably have to overcome lingering customer resistance to long in-store shopping trips (for fear of infection) and discretionary income pressure potentially far greater than in the 2008-09 recession. Subsequent waves of illness could force stores to close again in certain areas, if not nationally.
Still, the 2008-09 recession can provide some insight into the industry's performance in a conventional downturn, which can form the basis of a sectorwide forecast for stores that are open. It is important to note the differences between the two eras apart from the pandemic-related phenomenon: Apparel e-commerce was still in its infancy in 2008-09, and off-price chains' more recently opened (and therefore immature) stores were a larger portion of the base, creating a natural comparable sales lift. Still, quarterly results were variable, but Ross and TJX's Marmaxx unit (which includes T.J. Maxx and Marshalls) posted comparable sales growth that outperformed the change in U.S. GDP in 2008-09, with HomeGoods lagging until the economy hit its nadir. The overall linkage between the sector's performance and GDP was not strong during that time frame, however, and statistically inconclusive.
Although the 2008-09 recession was fairly quick to unfold, we also look to the sector's performance in the weeks immediately following the Sept. 11 terrorist attacks, considering the pandemic's almost-instantaneous conversion of a relatively strong economy into an environment rife with uncertainty. Ross, which at the time reported monthly sales (a practice that has since ceased), posted 4% comparable sales growth during the month ended Oct. 6, 2001, down from high-single-digit marks in the prior month, but still robust. The following two months saw 1% and 4% increases, respectively, before a return to the pre-event growth rate by year-end. We anticipate the level of perceived personal danger during the pandemic will be greater and the complexity associated with reanimating a dormant store network will be considerable, but the sector does have some history of resilience to deep recessions and sudden shocks.
We have long attributed the sector's resilience to a number of factors, including the appeal of quality products at deeply discounted prices in times of economic strain, with targeted customers' wide range of household incomes (roughly $25,000-$100,000, according to Burlington's management team) covering lower- and middle-income shoppers while leaving ample room for trade-down as the fortunes of erstwhile-flush customers in higher brackets change. We do not believe these fundamental dynamics have changed, as the chains' flexibility, opportunistic purchasing, and ability to respond to in-season changes in demand provide significant protections. Off-price sellers offer product at 20%-70% discounts and cater to vendors' desire for discretion by commingling brands on anonymous racks, protecting manufacturers' conventional channel pricing power by not tarring the brands offered with the perception of a steady discount presence. These practices should not change. We also expect the chains' long-term defenses against digital incursion will remain intact.
The challenge that off-price retailers face is bridging the current environment to a more conventional recession, spanning a period in which traditional defenses will be obscured by pandemic-specific phenomena, including social distancing restrictions on in-store traffic, possible customer reluctance to linger in stores, and potentially reduced demand for current fashion as social engagements are limited and Americans turn homeward amid a sharp recession.
In forecasting near-term outcomes for the sector, we base our expected U.S. declines in the first quarter (mid-40s on a comparable basis) on low-single-digit comparable growth in February followed by sharply falling results in March, culminating in closures that started in the month's late stages and left revenue virtually nonexistent through the rest of the period, likely continuing into mid- to late May.
We expect the broader U.S. economy to rebound fairly quickly as the pandemic eases, in response to aggressive stimulus measures. Still, the off-price chains are not likely to be considered essential during any subsequent regional rounds of closures as pockets of COVID-19 reappear, and they are likely to bear the volatility as they have virtually no e-commerce operations. (Ross does not have a digital sales unit. TJX only sells online via some of its banners and closed those portals alongside its physical stores. Burlington also ceased online sales and had planned to shutter its e-commerce operation entirely before the pandemic.) Our assumed 30%-35% comparable sales declines in the second fiscal quarter incorporate roughly 80% slides in May (as stores should mostly remain closed until the latter stages of the month), followed by a gradual progression toward mid-single-digit shortfalls come July.
However, with shelter-in-place orders easing and the economy opening (potentially including schools, by August or September), we anticipate another wave of infections will force third-quarter comparable sales down by the mid- to high single digits. This assumes roughly 5% of stores are closed at any given point, with the rest of the network posting low-single-digit comparable declines, a more tepid view than the chains' performance after Sept. 11 and in the depths of the 2008-09 recession, considering the pandemic's idiosyncratic effects (including possible customer or regulatory resistance to in-store shopping). Fourth-quarter performance should improve, though we still foresee a mid-single-digit decline with similar parts of the store network closed on a rolling basis, but with residual demand and economic recovery pushing open stores' sales back to more-conventional low-single-digit comparable expansion. Our industry assumptions lag our GDP projections as the chains recover from store closures.
Our industry forecast is stylized and normalized rather than a simple average of the companies' performance. We assume TJX's Marmaxx unit most closely emulates our industry forecast for the third quarter--not surprising considering its scale and generally on-point operations and merchandising capabilities. The differences between our forecasts for Marmaxx and Ross are mostly attributable to different comparable sales performance in the second half of the prior fiscal year; we see the two chains as broadly similar on a normalized basis. For both of those chains, our forecast corresponds to a 3% shortfall and 1% growth on a two-year stacked basis for the third and fourth quarters, respectively. Burlington's improvement efforts should continue through the year, leading to some outperformance as the assortment is shifted to more on-trend categories and management drives a chase mentality that emphasizes opportunistic, in-season purchases to be more responsive to customer demand.
We assume TJX's home unit (15% of overall sales) underperforms apparel-focused Marmaxx by around 2 points on a comparable basis in the second half of fiscal 2021 (which roughly corresponds to calendar 2020), as the more discretionary nature of home decor keeps such items lower on customers' priority list amid unsettled employment conditions. The international units, with significant presence in Canada, the United Kingdom, continental Europe, and Australia, should slightly underperform Marmaxx, as the non-U.S. segments include home decor and the off-price sector's value proposition is less familiar to shoppers in some of the company's growth markets.
Our forecast does not suggest Burlington is better positioned for the pandemic and an ensuing recession than its peers. Rather, we believe it is growing off a baseline that was artificially lower because of its suboptimal past practices. The chain has long been less efficient than its peers, which we attribute to factors such as overly large stores, an assortment more exposed to slower-growing legacy categories such as dresses and suits, and a less responsive merchandising operation (the last two of which Burlington's new management team started to address before the pandemic).
Each of the chains should outperform the full-price channel in the second half once (we assume) the bulk of stores are reopened. In the first half, department stores benefit from their e-commerce presence. We attribute the second-half differential to the appeal of discounts in a down economy and the sector's flexible, opportunistic sourcing practices that allow off-price chains to buy from a network of thousands of vendors based on availability and market conditions.
We continue to foresee economic profits long-term for Burlington, Ross, and TJX after the pandemic is lapped, underpinned by 2%-3% comparable growth, assuming roughly 1.5%-2% inflation and the remainder from marginal population growth and a continued gradual share shift from full-price stores. The heightened turmoil that the full-price channel faces on account of the pandemic, including potential bankruptcies, should boost product availability from already-strong levels, strengthening the chains' value proposition by improving access to items from well-regarded brands at attractive prices. However, the path to normalcy will not be linear, and in addition to agility and flexibility, the attendant elevated economic and execution risks demand liquidity.
Ample Resources to Survive Store Shutdowns
Ross and TJX issued $2 billion and $4 billion in new notes, respectively, in early April. Burlington raised just over $1 billion in convertible and nonconvertible debt in mid-April. The chains also drew down revolver capacity, with TJX borrowing $1 billion, Ross $800 million, and Burlington $400 million. The chains each have considerable liquidity, particularly as a share of overall expenses (even before excluding product costs). Burlington indicated that it has sufficient resources to meet its obligations even if it has earned its last dollar of revenue for fiscal 2020; we believe the other chains are similarly situated and expect revolver drawdowns to be repaid within the current fiscal year as the crisis eases.
We have attempted to isolate the off-price retailers' fixed (at least in the short run) expenditures. For Burlington, which breaks down its selling, general, and administrative expenses, we assume that rent is relatively fixed even during a shutdown, Burlington's sourcing costs are relatively sticky considering merchants' importance to sourcing product quickly for reopening and their relationships' criticality to the long-term value proposition, and marketing costs can largely be avoided while the stores are closed. Combined with a small part of cost of goods (to reflect inbound freight and distribution ahead of a reopening), we assume roughly 20%-25% of costs are fixed in the event of a network closure, using the prior fiscal year as a base. We assume the breakdown on an overall basis is similar across the chains for analytical purposes, but Ross and TJX are probably better positioned, considering their cost leverage.
Our analysis suggests that the retailers should have 11-15 months of available cushion, assuming stores remain shut for an extended horizon (this assumes 25% of costs are fixed, the more conservative end of our range). While the actual cushion is likely thinner as postpandemic store reopenings will carry costs for sanitization, restocking, and bringing staff back, we nevertheless see liquidity as sufficient. Our conclusion that the chains are reasonably well protected; even if we assume half of costs are not easy to avoid, we believe the chains have 5-8 months of available resources.
The chains have a history of significant cash generation, with free cash flow to the firm averaging in the mid- to high single digits at each of the three companies over the last 5-10 years. We expect cash generation to continue in the current fiscal year, ranging from 3% to 5% of sales. We anticipate cash generation even under considerably more pessimistic scenarios, with a current fiscal year cash burn only if second-half revenue falls by a high teens percentage, which would suggest roughly 20% second-half comparable sales declines versus our low- to mid-single-digit expectations (possible if a subsequent wave of infections leads to another national store network shutdown).
The chains' balance sheets have been managed conservatively, and there are no coming debt maturities of significant concern. We anticipate normalization will allow the conservatism to endure, with revolver drawdowns repaid as conditions normalize and debt remaining below twice adjusted EBITDA for each of the three companies by the end of the current fiscal year (with Ross and TJX net debt negative).
Although Ross and TJX are subject to credit facility covenants limiting lease-adjusted leverage to 3.25 times lease-adjusted EBITDA (Burlington's facility is secured and thus has fewer restrictions), the calculations are made on a rolling four-quarter basis, creating some flexibility. We believe Ross has the most cushion and would remain in compliance with its covenant even if its full-year adjusted EBITDA were 40% lower than our $1.6 billion fiscal 2020 forecast. TJX appears to have less flexibility, with a breach possible in the second half of calendar 2020 (fiscal 2021). However, we anticipate the chains' history of strong cash generation, robustness to conventional recessions, and historically conservative balance sheets make them good candidates for waivers (with reasonable concessions) should they become necessary, considering the circumstances triggering the violation. Our confidence in the chains' ability to secure waivers is bolstered by the inclusion of many of the chains' credit facility lenders as book-runners on their April debt offerings.
Long-Term Investors Should Focus on Normalized Strength
The severity of the near-term revenue and profit shortfall will depend on the timing of a return to normalcy. However, we contend that despite the magnitude of the possible profitability declines, longer-term investors should focus more on the state of the sector's long-term defenses against competitive threats as the valuation impact is not titanic. In addition to our baseline scenario, we analyzed the off-price retailers' valuations assuming more pessimistic near-term reopening outcomes (holding our long-term forecasts constant).
Scenario 1: Baseline Assumptions
Our valuations of the off-price apparel retailers assume sharp declines in first-half sales, based on store network shutdowns that extend from their late March start dates to approximately mid- to late May. We expect conditions to remain choppy in June, with a roughly 10% comparable sales decline as customers overcome hesitation to shop in stores, chains become accustomed to accommodating social distancing practices, and in-store assortments, frozen in late March, are transitioned to more current merchandise. Comparable declines should moderate into the midsingle digits in July before deteriorating to around 7% in the third quarter as subsequent waves of infection force regional restrictions. We foresee recovery in the fourth quarter (albeit still at a low-single-digit comparable decline versus fairly strong conditions in the prior-year period) before mid-20s comparable growth in the next fiscal year as the pandemic is lapped. For stores that remain open, we assume low-single-digit third-quarter declines and low-single-digit fourth-quarter upticks, with around 5% of stores closed at any given point. While the chains have expanded their footprint by a mid-single-digit percentage annually for the last several years, we anticipate pandemic-related construction delays hold growth in the low single digits in calendar 2020, before an expansion schedule that is slightly more brisk than usual in the following year as conditions normalize. In all, we foresee low-single-digit two-year compound annual revenue growth before past mid- to high-single-digit marks reassert themselves starting in calendar 2022.
Scenario 2: Additional Regional Closures With Greater Resistance to In-Store Shopping
In a more pessimistic reopening scenario, we assume the road to recovery is longer, with store traffic limits, customer reticence to spend extended periods of time in stores (often necessary in off-price as shoppers search for bargains and determine sizing for unfamiliar brands), supply and store labor disruptions, and challenging economic conditions conspiring to hold sales down. We assume roughly 10% of stores are closed on account of health conditions at any given point, with low- to mid-single-digit comparable declines for open stores persisting through the second half. Associated cost deleverage creates greater pressure on operating margins, pushing 2020 operating margins around 100-150 basis points lower than in our baseline scenario. Recovery comes in calendar 2021 as the pandemic is lapped, such that the chains' two-year compound annual revenue growth is roughly flat, with profitability approaching prepandemic levels but somewhat behind our baseline scenario.
Scenario 3: Second Nationwide Store Network Shutdown in the Fall
In our third scenario, we assume the easing of social distancing and stay-at-home orders triggers a significant second wave of infection, leading to a repeat of nationwide closures that shut all stores for another two months starting in late autumn (with conditions until then mirroring the more pessimistic of the earlier two scenarios). Conditions would likely remain difficult until a vaccine emerges in early calendar 2021. As with the other scenarios, we assume e-commerce does not play a significant role for any of the chains, although pressure to develop a basic online sales presence that remains available through the shutdowns would probably rise, with the aim of generating at least some revenue even if the channel is suboptimal for off-price retail. The assortments would likely differ (as has been the case for TJX's and Burlington's online offerings in the past), considering individual vendors' varying levels of receptivity to selling via off-price online.
Our valuations of Burlington, Ross, and TJX do not vary dramatically in the three scenarios outlined, despite significant differences in calendar 2020 outcomes. Among the scenarios we outline, patient investors should look to the cadence of a recovery as a potential source of buying opportunities.
While TJX should see some benefit from geographic diversification, we assume its home decor banners should be more challenged than apparel globally as shoppers defer discretionary purchases. While the timing of recovery should be different across countries and banners, we do not anticipate the cadence has meaningful implications for long-term investors.
With Off-Price Shares Rich, Look to Full-Price Retail for Discounts
Despite our favorable view of the off-price sector, we suggest prospective investors await entry points that provide greater margins of safety. Although the shares trade near our valuations, we believe the sector is worth monitoring for opportunities, as the volatility generated by the pandemic may create purchasing opportunities as more near-term oriented investors react to quarter-to-quarter results that should be significantly influenced by the timing of reopenings and a choppy demand and traffic environment.
Over the longer term, we believe Ross carries the least risk, considering its relatively simple operation (one primary and one secondary banner, focused on the United States) and strong performance record. TJX provides upside opportunities as its international unit grows and its Homesense chain expands in the U.S., though its home decor-oriented chains should be something of a disadvantage in the near-term as discretionary purchases are deferred (we similarly anticipate that the Homesense rollout will be slowed somewhat as the opening cadence is modulated based on economic conditions). Burlington likely carries the most upside potential against our expectations but also the most risk. With a turnaround under a new management team underway, the chain has much to do in order to improve its merchandising capabilities, shift its assortment toward more on-trend categories, and gradually move to smaller stores that are more efficient and provide a better shopping environment. Should the company achieve its objectives with more of a linear progression than we expect and on a faster timeline, our valuation could prove excessively conservative. Still, the uncertainty inherent in the present environment leads us to counsel forbearance.
While waiting for a more attractive off-price buying opportunity, we suggest investors look to the full-price channel, particularly no-moat Kohl's and narrow-moat Nordstrom. Although we readily acknowledge department stores' struggles as retail digitizes and competition intensifies, we believe our forecasts adequately reflect the industry's realities yet still suggest that certain chains offer upside potential.
For Kohl's, an unprofitable 2020 (which should include 30%-40% first-half comparable declines as stores are shut, moderated somewhat by e-commerce; we also anticipate it will be able to secure a pandemic-related waiver of leverage restrictions in its credit agreement) should yield to a return to trend in 2021. Although our $42 per share valuation suggests the shares trade at a nearly 60% discount, we believe our forecast does not lack conservatism. We assume negligible comparable sales growth with modestly declining operating margins over the long term (4.8% in fiscal 2029 versus 6.1% in fiscal 2019), with adjusted returns on invested capital below our 9% estimate of weighted average cost of capital. Still, the operation is not without value, and we believe current market valuations are overly pessimistic. While Kohl's is under considerable pressure from online and off-price rivals, the full-price department store channel is not expected to disappear overnight, and a $4 billion e-commerce operation (around 20% of fiscal 2019 sales) offers a meaningful beachhead for the company to complete an omnichannel transition.
For investors willing to take on exposure to a somewhat higher customer income stratum but with the benefit of a narrow economic moat, we see opportunity in Nordstrom, trading at around a 50% discount to our $37 per share valuation. Although its upscale positioning makes it vulnerable to economic downturns (with net sales down 6% in fiscal 2008), we believe the company has competitive advantages over other retailers due to the strength of its brand, which underlies our narrow moat rating. With its off-price unit that should be able to cater to the needs of strained customers (albeit not quite as well as dedicated off-price retailers that are more flexible), an established e-commerce unit that accounted for one third of 2019 sales, and a smaller store footprint than no-moat Macy's M and other rivals, we see Nordstrom as relatively well positioned to manage industry turmoil. Although we expect it to need covenant relief (which we believe should be attainable), we anticipate Nordstrom will re-emerge from the current crisis into a long-term environment where it should be able to deliver low-single-digit top-line growth against mid-single-digit adjusted operating margins.