First-Quarter Weakness Makes This Retail Stock an Attractive Buy

We believe  TJX Companies (TJX) offers investors an attractive domestic and international growth story, strong free cash flow generation, and a proven record of success in both strong and weak economic environments through its T.J. Maxx, Marshalls, HomeGoods, TJX Europe, and TJX Canada stores. With its experienced management team, compelling discounted offerings, and competitive advantage in scale and inventory management, we see low risk in strategy or execution.

We think investors have overreacted to TJX's announcement of first-quarter comps at the low end of guidance, and earnings per share that were slightly off because of foreign currency exchange rates. We continue to believe that TJX is best in class, with lean inventory levels, quick turns, and discounted merchandise at attractive margins--the basis for our narrow moat rating--and that its low-price offering of branded products is compelling to a wide demographic and geographic audience. We think the company is perfectly positioned in this economy to take advantage of both the excess of inventory available and consumer price sensitivity. Overall, we were impressed by the company's ability to manage merchandise margins and inventory levels in a quarter that had significant weather headwinds, and we see no change to our long-term growth projections or our $67 per share fair value estimate. We would recommend buying into the current weakness.

In our opinion, weather was the primary reason for the top-line shortfall. Comparable sales in the first quarter increased 1%, at the low end of guidance for 1%-2% growth and below our full-year expectation for a 2% increase. However, comp sales were very strong in Europe, growing 8% year over year, and there was a 4-point spread in comp performance in weather-affected regions versus unaffected regions at Marmaxx, with an even greater difference at HomeGoods. Had weather not been a factor, we believe performance would have come in closer to the high end of guidance and in line with our expectations. Because of the lean inventory model, TJX has the ability to quickly adjust its product offering and mix, and we expect that adjustments to the juniors offering, pent-up demand in weather-related regions, and a 35% increase in marketing impressions at Marmaxx in the second quarter could drive accelerated growth. Overall, we see no material change to our full-year revenue or pretax profit margin estimates.

Our Fair Value Estimate Is $67 per Share
Our fair value estimate of $67 per share implies a fiscal 2015 price/earnings multiple of 21. The stock is currently trading at a price/earnings multiple of 19 times, which is in line with TJX's three-year historical average of 19 times.

We are modeling 6% revenue growth, 8% operating income growth, and 8% adjusted EPS growth (which includes an increase in both interest expense and tax rate) in fiscal 2015. We expect revenue growth to be driven by a 2% increase in comparable sales on increased traffic and ticket and by a 5% increase in store count. We think the large open to buy and freshness from frequent inventory updates will drive sales and help the company finish the year strong.

Over the next five years, we see the most significant drivers of valuation to be new store openings, margin expansion, and continued share repurchases. We model a five-year revenue compound annual growth rate of 7%, driven by 5% average annual growth of the store base. At 4,166 stores in fiscal 2019, our model is in line with management's belief that it can expand the store base to 6,075. We model that operating margins to expand from 12.2% in fiscal 2014 to 13.2% in fiscal 2019. We expect margin expansion to be aided by a 50-basis-point lift in gross margins to 29.0% from better inventory management resulting in a decreased level of markdowns as well as from expense leverage on buying and occupancy costs. The remainder of the operating margin expansion comes from our expectation for scaling of the European business. Management has been an active buyer of its own stock, repurchasing approximately 15% of the shares outstanding over the past five years.

Cost Advantages and Proprietary Inventory System Make for a Narrow Moat
The apparel retail space offers limited opportunities for sustainable competitive differentiation, but we believe TJX has achieved this through cost advantages and a proprietary inventory management system. The company has generated a 19% average return on invested capital over the past three years, and we see it continuing to achieve the same returns above our cost of capital estimate for at least the next 10 years. We forecast a 10-year average ROIC of 20% versus our cost of capital assumption of 9.8%. As such, we award the firm a narrow moat rating.

Through its off-price retailing model, we believe TJX has achieved significant bargaining power with suppliers. The company offers wholesalers, department stores, and specialty stores the opportunity to clear excess inventory at very favorable terms to the supplier. These stipulations include a willingness to purchase less-than-full assortments of items, styles, and sizes as well as quantities ranging from small to very large. Because TJX is the largest off-price retailer and has international operations, it is uniquely positioned to manage large volume and disperse merchandise across a geographically diverse network of stores and to target specific markets. A large cash balance enables the company to pay suppliers promptly, and it generally does not ask for typical retail concessions (advertising or markdown allowances), delivery concessions (delayed deliveries), or return privileges. In return, TJX is able to acquire brand-name merchandise at a significantly discounted price and then sells it at a 20%-60% discount to traditional retailers.

Scale has also given TJX better access to the supplier network. The company has more than 900 buyers stocking inventory from more than 16,000 vendors in 60-plus countries. We think the size of the buyer force is an essential component of the company's opportunistic buying strategy of purchasing inventory for the immediate or upcoming season. The large vendor base allows buyers to capitalize on current market trends and source only the most popular fashions.

Finally, a unique inventory strategy coupled with an effective inventory management system has allowed TJX to achieve above-average revenue growth and profitability. As commercially available retail inventory management systems are not readily adaptable to the off-price retailing format, TJX has developed a proprietary system to meet its needs. This system has effectively matched store merchandise to local preferences and demographics and has maintained lean inventory levels. In fiscal 2013, TJX posted an inventory turnover rate of 59 days versus the peer group average of 88 days. We think high inventory turnover not only minimizes markdowns but also keeps the merchandise fresh and increases the frequency of customer visits. In our opinion, the development of this proprietary inventory management system gives the company a significant competitive advantage as the system would be costly and time-consuming for competitors to build and fine tune.

Although we believe these competitive differences will continue to benefit TJX for at least another decade, we do think they will eventually erode as current competitors increase in scale and invest in more-efficient inventory management systems. Additionally, we cannot rule out the threat of new competitors emerging either through traditional or online storefronts. These limitations keep TJX's mode from expanding to wide from narrow.

Growth Strategy and Inventory Management Keep Rivals at Bay
Although other U.S.-based off-price retailers are increasing their footprint and various international discount apparel competitors are developing a U.S. presence, we assign TJX a stable moat trend. Competitors such as  Target (TGT),  H&M (HM B) ,  Zara (ITX), and  Uniqlo (9983) offer products at a competitive price point, but their private-label merchandise is materially different than the brand-name and designer fashion stocked by TJX. The presence of these competitors has had little impact on TJX sales, with fiscal 2013 same-store sales growth reaching 7%. We take this as a sign that customers are differentiating among the offerings and that the presence of these competitors is not eroding TJX's compelling price offering.

 Ross (ROST) and  Kohl's Corp (KSS) are more similar to TJX in that they offer various brands under a single roof. However, we do not see a meaningful shift in scale as we expect new store growth at Kohl's and Ross to be matched by TJX. Ross has 1,253 stores and Kohl’s has 1,155 stores, while TJX has 3,119. On a selling square footage basis, TJX had 70 million square feet by the end of fiscal 2013 versus Ross' 28 million and Kohl's 83 million. Even though competitors are actively expanding their store count, TJX is also executing an aggressive domestic and international growth strategy that includes an e-commerce piece. We think this will mostly offset competitor growth and preserve the existing scale differential.

We also see TJX's inventory management advantage as unlikely to erode. As we think competitors would need to make significant investments in technology and people to match TJX, we do not see this advantage eroding anytime soon. Ross does have its own proprietary inventory management system but will probably not match TJX's inventory turns because of its packaway policy. We think the gap between TJX and its competitors is unlikely to change, and we give the firm a stable moat trend.

Management Holds Exemplary Record of Shareholder-Friendly Activities
The management team has extensive retail experience within and outside the company. Carol Meyrowitz has been CEO since 2007 and was president from 2005 to 2011. She has held various merchandising, consulting, and executive roles since joining TJX in 1987. Bernard Cammarata, who led TJX and its former TJX subsidiary and T.J. Maxx division from the organization of the business in 1976 until 2000, still serves the company as chairman of the board. The CEO's compensation totaled approximately $21.8 million, including a base salary of $1.4 million, stock and option awards of $11.4 million, incentive plan compensation of $6 million, and $2.7 million in deferred compensation for the past fiscal year. Although we think this is a little on the high end, TJX shares rose 32% in 2012 and net income increased 27% that fiscal year, so performance was strong.

The 11-member board comprises Cammarata, Meyrowitz, and nine independent directors. With this high level of independent participation, we consider the corporate-governance structure to be fair. Collectively, insiders control approximately 0.5% of the equity, with institutions owning 95% and funds the remaining difference. More than a thousand institutions hold an interest in the company, with only FMR and Vanguard holding more than 5% of shares outstanding, so we are pleased with the diversity of ownership. Management has actively participated in shareholder-friendly activities in the form of dividends and share repurchases. Over the past 10 years, the company has returned an average of 7% of market capitalization to investors. Overall, we assign the firm an Exemplary stewardship rating.