2 Best in Class Brick-and-Mortar Retailers

The brick-and-mortar retail world has been haunted by the shadow of Amazon for nearly a decade, but some companies are still managing to attract customers into their stores and keep shareholders happy.

In this episode of Industry Focus: Consumer Goods, Motley Fool analysts Vincent Shen, Sarah Priestley, and first-time podcaster Addie Lalier talk about TJX (NYSE: TJX) and Ulta Beauty (NASDAQ: ULTA), two retailers that are defying headwinds for the industry. Learn about how these companies are managing to do so well and how sustainable their impressive growth will be going forward.

A full transcript follows the video.

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This video was recorded on June 27, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. This is your host, Vincent Shen. It's Tuesday, June 27th. I'm excited to welcome two Foolish guests to the studio today. First, we have Fool.com editor and analyst Sarah Priestley. We're also joined by one of our summer interns, Addie Lalier. Thanks for being here, guys.

Sarah Priestley: No problem, thank you very much for having us.

Addie Lalier: Yeah, thank you for having me.

Shen: Sarah, you have been on a bit of a podcast hiatus. Do you remember the last time you were on the show?

Priestley: I don't even remember, no.

Shen: It's been that long.

Priestley: Back by popular demand.

Shen: You are back by popular demand from me, at the very least. Addie, this is your first time on a podcast, right?

Lalier: It is. I'm an editorial intern here at The Fool, and I'm a rising senior at UNC Chapel Hill studying business journalism.

Shen: So this is quite fitting for you.

Lalier: This is, and I'm really excited to be here.

Shen: Perfect. I'm really excited to have you guys on. I think our Foolish listeners will be really excited to hear what you guys have to say about some of our companies today. Our main discussion is regarding some best in class brick and mortar retailers. We've been really focused in the past few weeks and months on retailers, including department stores, restaurants that have been beaten down. We're going to go to the opposite side in terms of the ones that are managing to outperform.

But before we do that, I want to offer a quick update on the IPO world. As it turns out, this is expected to be one of the busiest weeks in some time for new listings, with almost 10 offerings pricing this week. One of those includes Blue Apron, the meal kit delivery company that helped to jump-start an entire industry just five years ago. Asit Sharma and I dove into the financials and outlook for Blue Apron on the June 6th episode of Industry Focus. Since then, the company has set a pricing range of $15 to $17 per share. During our previous discussion, I was off on the timeline for this deal. Blue Apron actually filed its draft registration statement confidentially. That's a popular option for qualifying companies that basically allows them to keep their financial and operating results private for as long as possible.

So rather than waiting a few months for Blue Apron's stock to hit the market, potential investors can pick up shares this week. The company is currently on its roadshow, with the deal expected to price tomorrow, June 28th. At the midpoint of the range, or $16 per share, the IPO itself will be a $480 million deal, and Blue Apron will boast a valuation of $3 billion. Asit and I will be sure to provide updates on the company in the coming months.

Now, onto our main topic for today, what I hope to be a more positive and uplifting outlook after covering, like I said, a lot of those beaten down department stores, those restaurants and other retailers. These are the companies that are defying retail headwinds and putting up a strong results and returns for our investors. First, we have the TJX Companies, the apparel and home goods retailer. While other department stores lay off employees, reduce their store footprints, and try to squeeze the value out of their real estate, TJX is putting up incredible results and returns for their shareholders. Sarah, Addie, for any Fools who are not quite familiar with TJX and the various chains included in its store portfolio, can you give us a quick overview of the company, its scale, and so on?

Priestley: TJX owns T.J. Maxx, Marshalls, HomeGoods, Sierra Trading Post, and Winners in Canada. They also own HomeSense, which is in Europe. So they have a lot of different brands. They're kind of a global company. As you said, they sell apparel, they also sell footwear, home goods, and stationery, makeup, they cover a huge spectrum. A lot of things you would expect to find at a department store, you'd probably find there. But they sell about 20% to 60% cheaper than what you would find elsewhere. They have about 3,800 stores. What makes them great for the purpose of this discussion is that last year, they sold $33.2 billion in sales, and e-commerce was 1% of that. So in all the discussion about how e-commerce is dominating and killing, causing the retail apocalypse, T.J. Maxx is really bucking the trend.

Shen: Yes. This is as close as you can really get to a pure play brick-and-mortar operation. And they've been really killing it in terms of the results. Their share returns also quite strong. I personally really enjoyed following this company. When I was younger, my grandmother actually loved shopping at T.J. Maxx and HomeGoods, and I remember going with her all the time. She would really patiently browse through each rack looking for just the right items, and we would end up spending over an hour there in the afternoon before we made our way through the whole store.

Investors will often hear management and analysts talk about this appeal of their stores, kind of like a treasure hunt. They have these popular brands, they have low prices, and a product selection that's constantly changing based on their buying habits and their vendors, what their vendors are essentially offering. That's obviously helped the company to deliver some strong results. I'd like to dive more into exactly the mechanics of how TJX is outperforming, and how it's able to deliver this experience and value for customers.

Priestley: I think the biggest thing for them is their inventory and supply chain management, which you touched on. I think the real selling point is the fact that you can go into a T.J. Maxx and spend a couple of hours there browsing, because it's never going to be the same inventory that you've seen before. So what allows them to do that is this inventory and supply chain system which is unparalleled. They custom built their own supply chain system. That means they can go to their vendors, they can buy smaller quantities than they would normally, they can buy different sizes, maybe don't take a lot of the perks that other retailers would in terms of the promotion expectations, returns expectations. So they have a lot of freedom to do this. What that means is that they end up with huge choice, huge selection.

And this is the crux of it: they can distribute that well globally, and they have the knowledge of the individual stores to make it suitable for that local area. And they talk a lot about having no walls. Their stores have no walls, they can make the content exactly what they expect people want to buy in that locality. And it's really hard to explain how unique that is and how difficult that is to replicate. Supply chain systems are notoriously very cumbersome and hard to operate. The fact that they manage 18,000 vendors worldwide on their system and manage to deliver the granularity that they do for the individual stores is incredible. I think some of that is through the fact that they have a thousand buyers worldwide. That number of buyers, plus the relationships they're establishing, is a huge plus.

Shen: So, really they have this army, essentially, of buyers out there, ready to connect with whatever vendor it may be. The 18,000 I think is really impressive in that it shows how much less they might rely than some of their competitors on certain key brands, because ultimately what customers go in when they look for is something new, that treasure hunt. They don't need to always necessarily have the same amount of some major brand. I think, in terms of what shoppers see when they enter a Marshalls or T.J. Maxx, you mentioned the no walls, and how the floor plan is very flexible. That's also similar to the fact that in terms of the way they stock their stores, their buying habits, the fact that some of the things that they buy, they will put on the floor that very same season, if not the next season, whereas traditional department stores will often make their purchases months in advance. And what that basically allows the company to do is stay on top of popular trends, see what's selling well, and that information flows back to the vendors, as well, as valuable data and feedback.

So this product selection and the discounts that the store offers, is powering the strong foot traffic, and keeping customers coming back. To quantify that, I think it's important for investors to look at one metric, and that's inventory turnover. I covered this metric in detail last May. Basically, what it tells an investor is how many times a retailer will sell through its entire inventory in a given period of time, usually a year, and usually the higher the better for this number. TJX boasts an inventory turnover for the last 12 months of 6.2x. To give you a little bit of perspective, Macy's is just 2.7x, Nordstrom 4.4x, and Kohl's 2.9x. In other words, while it might take TJX about 60 days to sell through their entire inventory, Macy's and Kohl's would need over 125 days, and Nordstrom would need about 80 days. When you put that in perspective, what it amounts to is that, it takes more time for the competition to convert that inventory to revenue and essentially cash, while TJX is moving on to their next season or collection of apparel to offer their customers.

Listeners now have a better understanding of why TJX is leading the pack. I think it's a natural question, though, to ask, you mentioned their digital business is only 1% of their revenue. I think a lot of people are wondering at this point whether it can maintain that kind of balance to its business and also scratching their heads wondering why, while Amazon is eating everyone else's lunch, they haven't managed to do the same with TJX. And is, essentially, the company's moat big enough to hold off online competition and maintain the success that it's seen with this pure brick and mortar operation? Is the moat big enough to do this?

Priestley: I think so. I think there's a few things that protect them from the Amazon effect. One, which you kind of touched on, is the choice. They're not reliant on one particular brand. This isn't Nike trying to sell through its own website. They have Nike and they have Under Armour and they have every sports apparel company you could want. And that's the benefit, because they can move with the trends, as you were describing. I think the other thing is the fact that the average ticket size for TJX generally is so small, it doesn't necessarily make sense for people to make those purchases online. The third thing is the experience. They offer value and they offer the whole treasure hunt experience, and you can't necessarily get that online. I generally believe people don't think they know what they want when they go to T.J. Maxx or Marshalls or even to HomeGoods. But the fact of the matter is, you get in there, you see these great deals, you find something that you want, and they give people a reason to go to the stores.

Shen: I think that makes a lot of sense. Last thing I do want to touch on, besides what we're bullish on, is some of the risks that the company faces, in terms of, some of the things that come to mind for me are the fact that it has over 3,000 stores, I think management has spoken to a long-term target or runway of over 5,000 potentially across it geographic footprint. But ultimately, there's always concerns in terms of, a lot of its competitors are hurting now, because they went through this huge period of overexpansion. There's more retail space in the United States than any other country. Is that a concern? Is that something that TJX might have to deal with in terms of, they reach a point where they have so many stores that they can't even find all those good deals from vendors, for example, to keep items on the rack and fill them out?

Priestley: It is definitely a concern, especially when you consider that Macy's has started Macy's Backstage, and there's Nordstrom Rack, and you've got [Saks Off Fifth], so there's a lot of competitors that are rising that are going to be competing for the same inventory. And that's where that whole vendor relationships really comes into play. I do think there is the potential for risk of overexpansion here. At the minute they are 5% of the U.S. apparel and footwear market.

Shen: So still a very small portion.

Priestley: Still very small. If they're on track with their projected expansion, it would be 7%. Again, still small. I think they should be careful of it. One thing to note is they've had this question, they've been challenged on this for the past 40 years.

And if you look on their investor relations website, they actually have a chart that shows that, through multiple downturns, they haven't been affected. They have had 21 years of comps improvement, 21 years of sales improvement, 20 years raising the dividend. So I think that you have to give them some credit to the fact that they know how to navigate these choppy waters.

Shen: Sure. Yeah, those are two decades, those are long-term results, and I think investors definitely have a lot to follow and a lot to be excited about when watching this company going forward.

Our next company is Ulta. Before we start diving into that and how they're outperforming as well, I want to give a shout out to one of our Foolish listeners. His name is Michael Palmer, he's from Illinois. Michael reached out to us recently. Anyone can do so, by the way, via Twitter @MFIndustryFocus or email to industryfocus@fool.com. He shared what has officially become my favorite Industry Focus-related story. I think a lot of the IF crew shares that sentiment. Michael wrote to us, he said, "I'm pretty sure the last episode of CG Industry Focus got me out of a traffic ticket. I was listening to the section on Wal-Mart doing home delivery through employees," that was on my show, by the way, "got a little too focused on it and made a rolling stop through a stop sign. The cop pulled me over and asked if I knew what I did. I honestly said no and blamed the podcast, since I was getting deep into it. He asked me what it was about and I explained the general Motley Fool idea and the Wal-Mart piece specifically. Apparently he had just bought Amazon stock for his kid, because he thought all brick-and-mortar was going away." Quite relevant to this episode as well, "So we chatted about Wal-Mart possibly being a good play with a dividend and footprint in e-commerce business. We also both had taken lumps on Under Armour over the past couple years. Next thing you know, 20 minutes have passed. He gave me back my license and said, 'Good talking to you, and be careful with the stop signs.' Looks like I made a new investing buddy, and you hopefully got a new listener." I'm really excited that I was able to personally help Michael here get out of that traffic ticket, and hopefully that officer is also a loyal follower and listener for Industry Focus as well.

But wrapping up our show here and our discussion, remember that Ulta is a specialty retailer. I consider them very much so, in terms of strength in their business model, similar to TJX, though they probably have more of an online presence that you will discuss, Addie. Can you give us a quick rundown of what they do? Then we'll dive into some of the bright spots for them as well.

Lalier: Yeah, absolutely. Ulta is the largest beauty retailer in United States right now, and it offers cosmetics, fragrance, skin care products, hair care products, and full-service salons in their stores. They currently operate 990 stores in 48 states and are located primarily in strip malls in suburban areas. Along with their physical store presence, Ulta has a strong online presence as well as a downloadable app. In the last 12 months, Ulta sales increased 23.7% to $4.9 billion.

Shen: Very nice. Our interns have actually been pitching stocks on a weekly basis as an ongoing project. Ulta was a company that you actually covered last week, Addie. I'll let you take the reins here in terms of, what do you think are the main things, for TJX it was the evolving inventory that they offer, the discounts, that value, and the feelings that shoppers get when they go into one of their stores. What is it that Ulta offers to its customers that has allowed them to really outperform as well?

Lalier: I think there are two main things that really drive Ulta ahead of everyone else. One is, their physical stores and how it feels to go into that store, and the layout, and how it's open, and the staff is friendly, and there's so much selection, and there's the salons, and there's a placement of the services such as the Brow Bar, that's at the front of the store -- I think when you really go in there, everything is so easy to navigate. Whether you're looking for one thing, you end up finding other things. It's really the layout of the store. And I think that other stores don't really have that as strong as Ulta does. Another huge thing is the loyalty rewards program. It's called the Ultamate Rewards program. It's pretty much one point for every $1 you spend. The more points you get, you get a monetary reward. So the next time you buy something, you get X amount of dollars off the more you accumulate. I really think that drives people and is an incentive to buy more. And they're super guest-centric, their business model, whether it's the loyalty system, and there's coupons in the advertisements. I think overall, they really focus on the customer relationship, and wanting them to come into the stores, and rewarding them for doing so.

Shen: Sure. And it's not just the feeling, in terms of the layout. While that is all very conducive to that positive shopping experience, these benefits of their layout, of offering some services in addition to the products, and also the loyalty program, they have a quantified effect on the business. From what I've seen, some of the loyalty program members, similar to other programs that we've seen, in terms of companies like Starbucks, for example, they tend to be much better customers. How does that end up panning out for the company?

Lalier: Absolutely. Sales from loyalty members actually accounted for about 90% of their revenue. Which is huge, yeah. That speaks for itself that this program is working, and customers are really appreciative of the rewards they're getting. Another big part of Ulta is their salon service, which is huge, and no other beauty retailers really have that. That really differentiates them. Actually, salon guests spend almost three times as much as non-salon guests, and shop two times more than non-salon guests. That's a huge metric in terms of what they're doing for their customers and how much they're spending.

Shen: That, frankly, reminds me of a lot of these different concept stores that certain other retailers have been trying, in terms of that you need to offer something beyond just what you're selling to bring people in the door, and when you do, it becomes more of an experience for the seller. Everybody's talking about how especially younger consumers are looking for more of experiential spending rather than material spending. And I can see how, this is the kind of thing that, somebody can come in for their salon services, and while they're walking out, potentially browse for the various cosmetic products, things along those lines, and walk out with, in this case, what was it, three times bigger ticket size, right?

Lalier: Yeah.

Shen: Beyond their stores, they also do have a bigger digital presence than TJX, who we were talking about previously. Can you elaborate a little bit on what some of those efforts look like?

Lalier: Right. They have a huge e-commerce presence. Along with that, they also have a downloadable app where you can do the same things that you would do online. So you can shop, you can see your rewards. There's actually a thing called the Glam Lab where you can test out products. Which, in terms of other retailers selling products online, I think this is where Ulta has a competitive advantage, because when it comes to beauty products, you want to be able to smell it and try it and everything. Customers can do that at Ulta in stores. But then, also, that transfers over to, they can go home and order it online. Whereas, other companies, such as Amazon, you can't get that same experience. So I think they really hit all channels, whether it's through the app, through the online sales, or in store, they're super omni-channel, and I think customers flow through all three of those pretty frequently.

Shen: Sure. I'm sorry, I don't understand for this Glam Lab thing, is that a digital way of trying things on? How would that even work?

Lalier: Yes. You upload a selfie of yourself, and you can try on different makeup. I know.

Shen: That's impressive. Following a similar line of thinking with our TJX discussion, there is a lot of competition in this industry. You have other big names in cosmetics and makeup like a place like Sephora. I guess the question becomes, the growth rate that Ulta has been seeing so far, do you guys view that as being something they're going to be able to sustain longer-term? What is, essentially, the moat for this company?

Lalier: I think they're completely sustainable. They're penetrating the U.S. market really strongly right now, but their e-commerce presence is huge. I think they can transfer over to that at any time, and they really want to grow that as well.

Priestley: Yeah, I think the online business grew 56% last year. That is just astronomical when you compare it to other retailers. A lot of people are going to be enviable of that. So, they obviously have cracked the omni-channel. I do think it's a lot down to the experience and the fact that they are value-driven, too, because you're going to risk the Amazon, the Best Buy issue, that people are going to go into one of these stores and try to make up, and if they can get it cheaper elsewhere online, they may do that.

Shen: Yeah, showrooming. That was a huge issue for some of these big box stores. I am curious, if they benefit from a similar situation, with TJX, it was the ticket size. I know that cosmetics can get very expensive, but I'm curious sometimes if it isn't just more convenient, once you're there and you've tried it and you like it, then you just want to take it home with you?

Priestley: It's instant gratification.

Shen: That can even beat a one or two-day shipping offer from someone like Amazon. My last point that I would like to discuss is what some bearish investors might be looking out for, or people who are concerned in terms of potential headwinds for the company. What are things that you guys are watching that you think our listeners should also keep an eye on, despite how well the company has been doing?

Lalier: I think when people think of Ulta and any beauty retailer, their minds jumps to Sephora. And I think Sephora is probably the closest competitor to Ulta. But I think they're very different. Sephora is chic and sleek. I think the overall business model is a lot different. Sephora is located in malls and large cities, while Ulta is more spread out and vibrant and located in more suburban areas, strip malls. They're targeting some different people there. But one of the biggest differences between the two, touching back to the loyalty program is this different rewards system that they have going on, and how much Ulta focuses on its customers a little more so than Sephora. I think that's the one thing that's really putting them in front of them. And to go into some details on that, Ulta does the monetary reward program, where it's a point for $1. Sephora is more samples, you get sample rewards, or free shipping on orders X amount or more. I think it's really the monetary side of it or samples. And I just really think Ulta is one step ahead of Sephora by offering this huge variety of coupons and exclusive offerings in the point system.

Shen: So, despite the competition there, they have the leg up in terms of offering that stronger incentive.

Priestley: It's going to be interesting to see, as they expand into urban areas -- I know that's what they're starting to do now, into urban areas, and the places where Sephora is, people are going to be faced with a choice. They sell a lot of the same brands, and especially now, they're starting the MAC boutiques, which, am I right, Sephora doesn't offer those?

Lalier: Correct.

Priestley: So, to me, they're going to be duking it out.

Lalier: It's going to be exciting to watch, yeah.

Shen: Running out of time here, any last thoughts from you guys? Alright. Thank you very much for being on the show today.

And thank you, again, Michael, for that awesome story. Thank you, Fools, for listening. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!

Sarah Priestley owns shares of Under Armour (C Shares). Vincent Shen has no position in any stocks mentioned. Addison Lalier has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon, Nike, Starbucks, Twitter, Ulta Beauty, Inc., Under Armour (A Shares), and Under Armour (C Shares). The Motley Fool recommends Nordstrom and The TJX Companies. The Motley Fool has a disclosure policy.