Burlington Stores: Huge Upside, but High Risk

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As Amazon.com has upended the retail landscape, off-price chains have been among the few retailers to continue posting steady sales and earnings growth. Ross Stores (NASDAQ: ROST) has been especially reliable for the past few years, routinely posting comp-sales growth of about 4% and operating margins of at least 13%.

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Meanwhile, Burlington Stores (NYSE: BURL) has been an also-ran of the off-price industry for many years. Despite using many of the same techniques as its larger rivals, it lags far behind them in terms of margin performance.

That said, Burlington Stores has been improving its profit margin slowly but surely. If it can get anywhere close to the industry leaders in terms of profitability, the stock could make huge gains in the coming years.

Another quarter of solid improvement

Earlier this week, Burlington Stores posted strong third-quarter results. Comparable-store sales increased 3.1% year over year, even though unseasonably warm weather led to weakness in cold-weather apparel sales.

The company's profit margin also expanded dramatically. Gross margin increased to 42.2% from 41.2% a year earlier, while solid sales growth helped Burlington reduce its operating expenses as a percentage of sales. The net result was that earnings per share increased by roughly 30% (excluding the impact of a recent change in the accounting rules for stock-based compensation).

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Burlington Stores expects to continue growing EPS at a double-digit rate in the fourth quarter and in 2018. Still, management is calling for a significant slowdown in EPS growth relative to the past few quarters. Investors were hoping for more after the company had released a bullish guidance update in late October. As a result, Burlington Stores stock declined modestly following the earnings release.

Still far from best-in-class

Burlington's margin improvement this year continues a multiyear trend of margin expansion. Still, the company lags well behind Ross Stores, which has been the gold standard for profitability lately.

Indeed, Burlington Stores posted a pre-tax margin of about 6% last year, compared to nearly 14% for Ross Stores. Furthermore, its profitability is highly seasonal (and weighted toward the fourth quarter), making it more like department stores than its off-price peers. Despite its margin gains, Burlington's pre-tax margin was around 5% for the first nine months of fiscal 2017, whereas Ross Stores has reached new highs with a 14.4% pre-tax margin year to date.

This vast disparity in profitability has an obvious source: the low productivity of Burlington's stores. The average Burlington Coat Factory location is nearly three times the size of a typical Ross Dress for Less store but only does slightly more sales volume.

Profitability isn't the only way that Burlington Stores is a laggard. It also has a much weaker balance sheet than its rivals. As of the end of last quarter, Burlington had just $48 million of unrestricted cash on hand and $1.3 billion of long-term debt. In contrast, Ross Stores ended the quarter with more than $1.1 billion of cash and just $396 million of debt.

Some weaknesses could spell opportunity

Burlington's single-digit margins are a major weakness, particularly because the company has a weak balance sheet. This could be a dangerous combination in the event of a deep recession.

However, the company's low profitability also represents a big opportunity, to the extent that it is fixable. Burlington may never be able to match Ross Stores' margins, but just getting its pre-tax margin into double-digit territory would drive huge profit growth. That's a big reason why Burlington Stores stock trades for 22 times forward earnings despite the company's obvious flaws.

Recently, Burlington Stores has made a concerted effort to reduce its inventory, in order to offer customers a fresh merchandise assortment every time they shop. This has contributed to its recent margin expansion. The company is also making better buying decisions under the leadership of Chief Merchandising Officer Jennifer Vecchio, a 14-year veteran of Ross Stores.

Most importantly, Burlington has acknowledged that its cavernous stores are too big. At times, the company still presents the size of its stores as an advantage -- it can offer a wider selection of merchandise than other off-price retailers -- but 80,000 square feet is simply too much space. With a store that large, there's a real risk of carrying too much inventory just so the store doesn't seem empty.

Fortunately, fixing this problem is relatively straightforward. The company is now aiming for 40,000-50,000-square-foot locations for its new stores. New stores averaged 51,000 square feet in 2016, and 44,000 square feet more recently. Burlington Stores is also relocating or downsizing some of its existing larger stores to the new prototype.

The early results from this strategy are promising, as evidenced by Burlington's strong earnings growth this year. If this momentum continues, Burlington Stores has huge margin upside in addition to the significant revenue growth potential shared by most off-price retailers. That could drive the stock much higher in the next few years.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Adam Levine-Weinberg is long January 2019 $50 calls on Ross Stores. The Motley Fool owns shares of and recommends AMZN. The Motley Fool has a disclosure policy.