Ross Stores Offers Great Values for the Consumer and a Fair Value for its Investors      Rating: Neutral

We recommend Ross Stores, Inc. (NASDAQ ROST) as a Neutral as investors have bid up its shares because they recognize its strong revenue and profit growth as well as disciplined capital allocation.

RECOMMENDATION

We have a neutral rating on ROST.  We believe that investors have bid Weyerhaeuser’s stock up by 33% this year because they have recognized that ROST is able to generate solid revenue growth, strong profit growth and supersized returns on investors’ capital.  However, we love the fact that it has increased its store base from six stores in 1982 to 1,253 in Q2 2013.  We believe that the company’s fair intrinsic value per share is $76/share and we believe that the run-up in ROST’s stock price has resulted in the near convergence of ROST’s market price $72 as of September 25) with its fair intrinsic value.  We encourage investors to go long if the company’s share price was to decline to $61 in the absence of any significant company-specific information, as it would be nearly 20% below its fair intrinsic value at $61/share.

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Source: Morningstar Direct

ROST’s closest competitor in the off-price retailing segment is The TJX Companies (TJX).  TJX is of interest to us as we are located in Boston and TJX’s worldwide corporate headquarters is located in the Greater Boston suburb of Framingham. Both firms have been able to generate solid revenue growth, strong profit growth and supersized returns on investors’ capital.  ROST grew its revenues and profits at a slightly higher rate than TJX however TJX is a larger company ($40B market capitalization than ROST ($15.5B).   ROST and TJX have been able to generate significantly stronger financial performance than traditional retail department stores.  We were surprised that Morningstar rated ROST as having “No Economic Moat” while giving TJX a “Narrow Economic Moat” rating since both have a similar business operations model and relative financial performance.  We like both companies but we have a slight preference for ROST since it is smaller than TJX and has more room to grow than TJX.

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Source: Morningstar Direct

COMPANY OVERVIEW

ROST and its subsidiaries operate two brands of off-price retail apparel and home accessories stores.

Ross Dress for Less: Ross Dress for Less is the largest individual off-price apparel and home fashion chain in the United States.  TJX’s Marmaxx division has more stores than Ross Dress for Less but it is comprised of two different store chains (T.J. Maxx and Marshall’s).  Ross Dress for Less operates 1,131 stores in 33 states, Washington DC and Guam. 

dd’s DISCOUNTS: dd’s DISCOUNTS features a more moderately-priced assortment of first-quality, in-season, name brand apparel, accessories, footwear and home fashions for the entire family at everyday savings of 20% to 70% off moderate department and discount store regular prices. dd’s DISCOUNTS operates 122 stores in 10 states.  The typical dd’s DISCOUNTS store is located in an established shopping center in a densely populated urban or suburban neighborhood and its target customers typically come from households with more moderate incomes than Ross Dress for Less customers.

The merchant, store, and distribution organizations for Ross Dress for Less and dd’s DISCOUNTS are separate and distinct. The two chains share certain other corporate and support services.

Both Ross Dress for Less and dd’s DISCOUNTS brands target value-conscious women and men between the ages of 18 and 54. ROST bases its strategic and tactical operational decisions from merchandising, purchasing, and pricing, to the locations of its stores on these customer demographic profiles. We remembered how TJX was able to derive a competitive advantage for its two flagship brands (T.J. Maxx and Marshall’s) by offering a wide assortment of product within each of its merchandise categories in organized and easy-to-shop store environments and we believe that ROST is successfully replicating it with its two different retail brands.

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Source: ROST’s FY 2012 Annual Report

Management: Michael Balmuth is the Vice Chairman of Ross Stores as well as its CEO.  He has been working with ROST since 1989 and he was previously a merchandising executive with the company.  Balmuth has been CEO since 1996 and he has overseen an impress record of steady, consistent growth.  Other notable executives include the following people:

  • Doug Baker-President and Chief Merchandising Officer of the dd’s Discounts Division.  Mr. Baker has 29 years of retail experience, including 18 as an executive with ROST.
  • Michael B. O’Sullivan-President and Chief Operating Officer.  Mr. O’Sullivan has 21 years of retail or retail consulting experience, including 10 with ROST.
  • Barbara Rentler-President and Chief Merchandising Officer of the Ross Dress for Less Division.  Ms. Rentler has worked with Ross’s merchandising operating since joining the company in 1986.
  • Michael Kobayashi-Executive Vice President, Supply Chain, Allocation and Chief Information Officer.  Mr. Kobayashi has been with Ross since 2004 as its CIO and has added the Supply Chain and Allocation portfolios to his responsibilities.  Before joining Ross Stores, he was a partner with Accenture’s Retail & Consumer Goods practice.
  • John G. Call-Senior Vice President, Chief Financial Officer and Corporate Secretary.  Mr. Call has served as a Senior Vice President, Chief Financial Officer and Corporate Secretary since 1997 (though he shed the Corporate Secretary responsibilities from 2009 to 2012). 
  •  Norman Ferber-Chairman of the Board since 1993 and Consultant to the company since 1996.  Mr. Ferber was a long-time executive leader with ROST and served as its CEO from 1988 to 1996.

We believe that ROST has a solid management team.  We love the fact that ROST’s management team has created an environment in which there is little management turmoil; the executives do not seek out the media limelight and go about their business of increasing shareholder value through solidly growing the company.  ROST’s corporate governance model was the antithesis of J.C. Penney’s (JCP) governance model under Ron Johnson.  JCP hired a rock-star CEO with a well-known media profile whereas ROST’s executives have a much lower profile than Ron Johnson does.  Ron Johnson had big plans for J.C. Penney that ended up failing big time.  Meanwhile, ROST quietly goes about solidifying its business operations and growing its store footprint.

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Source: ROST’s 1993-2012 Annual Reports

Ownership: Institutional asset managers own 91.9% of ROST’s shares, including 52.53% held by mutual funds.  The largest institutional holder is Fidelity, which owns 24M shares as of June 30, 2013.  Fidelity’s stake in ROST is worth $1.7B and represents 11% of ROST’s outstanding shares.  Five Fidelity mutual funds rank among ROST’s 20 largest mutual fund holders, including Billy Danoff’s Fidelity Contrafund and the well-regarded Fidelity Low-Priced Stock Fund.  The Five Star Akre Focus Institutional Fund (AKRIX) has 1.3M shares of ROST and although it only has 0.58% of ROST’s outstanding shares, it represents 5.87% of AKRIX’s portfolio.  ROST’s executive officers and directors as a group collectively own 5.89M shares worth $426M and representing 2.7% of ROST’s outstanding stock.  The three largest individual/insider shareholders are Director George P. Orban (2.8M shares), Chief Development Officer James Fassio (687K shares) and Chief Operating Officer Michael O’Sullivan (526K shares)

VALUATION AND PROJECTIONS

Our $76 intrinsic fair value per share is based our estimate that the company will continue to pay a $.60 annualized per share dividend during our estimate observation (Q4 2012 to 2016).  The company’s market price of $27.36/share is within 6% of our estimated fair value.  We have discounted this stream of cash flows at 11%, which is our firm’s minimum cost of capital for equity investment opportunities.  We expect the company’s we invest in to generate an 11% cost of capital (which is the ROE established by our state regulator for utilities).  We believe that regardless of whatever a company’s cost of equity or firm wide capital is calculated on Bloomberg LP, we believe that a company’s cost of capital should equal or exceed the 11% ROE of a reliable regulated utility. We expect ROST will generate 51% ROE for 2013, which explains why the company trades at 8.1X P/B yet its forward PE is only 16.25X.  While we are expecting its EPS to increase from $3.94 in 2013 to $6.44 in 2017, we believe that ROST’s share price reflects its expected future growth.  We expect that ROST will trade at 18X TTM in FY 2017.

We are expecting ROST’s EPS to increase on the strength of an estimated 10% increase in revenues from 2013 to 2017 and positive operating leverage resulting in its cost of goods sold and operating expenses increasing by 8%-10% during this period.  We are expecting the company’s net interest expense to be statistically insignificant as ROST only has $150M in debt versus $555M in liquid assets. ROST’s debt carries a weight-average interest expense of 6.45%.  $85 M of ROST’s debt is due in 2018, $65 M is due in 2021, and we believe that the company should strike a deal to refinance this debt to take advantage of historically low interest rates and save a few million in annual interest expenses.  We are expecting the company’s effective average tax rate to be 40% for our observation period.  We reiterate that investors should go long if the company’s share price was to decline to $61 in the absence of any significant company-specific information, as it would be nearly 20% below its fair intrinsic value at $61/share.

RECENT QUARTER (Q2 2013)

ROST’s total revenues increased by 9% year-over-year in Q2 2013 due to the opening of 79 net new stores between July 28, 2012 and August 3, 2013 and a 4% increase in “comparable” store sales (defined as stores that have been open for more than 14 complete months).  ROST’s sales mix remained relatively constant in Q2 2013 versus Q2 2012 and in H1 2013 versus H1 2012.   ROST’s total revenues grew by 8% in H1 2013 due to the opening of 79 net new stores between July 28, 2012 and August 3, 2013 and a 3% increase in “comparable” store sales.  ROST intends to address the competitive climate for off-price apparel and home goods by pursuing and refining its existing strategies and by continuing to strengthen its organization, diversify its merchandise mix, and more fully develop its organization and systems to improve regional and local merchandise offerings.

ROST’s cost of goods sold as a percentage of sales for Q2 2013 decreased approximately 70 basis points from the same period in the prior year.  This improvement was due to an 80 basis point increase in merchandise margin, which included a five basis point benefit from a lower inventory shortage accrual.  A 10 basis point increase in distribution costs partially offset the favorable merchandise margin trends. Freight, occupancy, and buying and incentive costs as a percent of sales were relatively flat to the prior year period.   ROST’s COGS for H1 2013 decreased by approximately 55 basis points from the same year due to its increased merchandise margin and a slight increase in distribution costs.  ROST’s selling, general and administrative costs as a percentage of sales declined by 10bp in Q2 2013 and H1 2013 due to positive operating leverage on store operating costs from ROST’s incrementally increases in its comparable store sales.

ROST’s diluted earnings per share for Q2 2013 was $0.98 compared to $0.81 in the prior year period. The 21% increase in diluted earnings per share is attributable to a 17% increase in net earnings and a 3% reduction in weighted average diluted shares outstanding due to ROST’s ongoing stock repurchase program. ROST’s diluted earnings per share for H1 2013 was $2.06 compared to $1.74 in the prior year period. The 18% increase in diluted earnings per share is attributable to a 15% increase in net earnings and a 3% reduction in weighted average diluted shares outstanding due to the stock repurchase program.

KEYS TO INVESTMENT THESIS

We like ROST’s very conservative balance sheet.  ROST has a very conservative balance sheet in that its shareholders equity is nearly 50% of its total assets and 93% of its total capital balance.  Furthermore, its liquid asset base of $555M exceeds its total debt of $150M.

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Source: Morningstar Direct

ROST’s primary revenue growth driver is its new store development and its secondary source is its sales from existing stores.  ROST generated positive comparable stores sales growth in 23 out of its last 26 years and its average comparable stores sales growth was 3.7%.  We can see that ROST’s comparable stores sales growth performance is steady but unspectacular.  ROST’s primary sales growth driver has been its new store development program based on its store count increasing from six stores in 1982 to 140 stores in 1988 to 1,253 in H1 2013 (9.16% CAGR from 1988 to 2013).

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Source: ROST’s 1993-2012 Annual Reports

ROST’s shares have enjoyed very strong dividend growth.  ROST’s split-adjusted calendar year dividend per share has increased from $0.0125 in 1994 to $.68 in 2013 and has grown by 23.1% during this period.  We also expect ROST’s dividend will increase by 20% from 2013 to 2017.  ROST began paying dividends to its shareholders in 1994 and its dividend payout ratio has increased from 14.1% in 1994 to 16.7% in 2012.

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Source: Bloomberg LP

ROST’s management disciplined program of capital management.  ROST has avoided costly empire-building acquisitions and has steadily returned cash to shareholders through increased dividends and share repurchases.  ROST has reduced its share count by nearly 30% since the end of FY 2003.  

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Source: Morningstar Direct

ROST’s share price is within 1% of its all-time high of $72.84 and 6% of our target price of $76.  We would be enthusiastically encouraging investors to load up on ROST if its share price was $61 or less.  Because ROST’s share price has bounced back from its 52 week low of $52.01 in December and is now within 1% of its all-time high of $72.84.

FACTORS THAT WOULD HELP BOOST ROST’S FAIR VALUE TARGET PRICE

  • ROST is able to boost its comparable stores sales performance.
  • The US avoids an economic recession due to ObamaCare’s potential negative impact.
  • Consumers recognize that ROST offers a rapidly changing assortment of fashionable, quality, brand name and designer merchandise at prices generally 20%-60% below department and specialty store regular prices, every day.
  • ROST is able to exceed analyst projections for its revenues, dividend growth and EPS
  • ROST generates strong revenue performance from its new store development program
  • Consolidation in the industry serving to reduce competition
  • The ability of ROST to ensure management stability and transitions. 

The inverse of these factors will serve as potential risks to the company which could reduce the profitability of the company and would be a negative to the company’s stock price

APPAREL RETAILERS INDUSTRY OUTLOOK

Sales for the 2012 holiday season were flat, as the National Retail Federation (NRF), a trade group, reported that such sales increased 3.0% from the prior-year period. For full-year 2012, the US Census Bureau reported that total retail sales (excluding motor vehicles and parts) rose 4.6%. 

We expect retail sales growth to moderate in 2013 as the consumer remains under pressure. We are concerned that the loss of about $1,000 in pay by the average worker over the course of 2013 resulting from the termination of the payroll tax holiday (in effect in 2011 and 2012), during which time the FICA tax rate was lowered to 4.2% from 6.2% will serve as a headwind to retail sales growth.  We are not optimistic about the economic impact of the new healthcare law.  Another potential headwind to growth includes interest rate increases due to uncertainty over Federal Reserve monetary policy and governmental budgetary policy. 

We expect another good year for off-price retailers, given their attractive value pricing, frequent in-flow of new merchandise, and their ability to move in and out of product categories quickly based on customer demand. We see the continued expansion of Ross Stores Inc. and The TJX Companies Inc. into new markets putting pressure on value competitors in the off-mall channel. The move by a few US retailers to close underperforming stores in the US has created an opportunity for foreign retailers to enter the American market. Among the first to arrive were Sweden’s H&M Hennes & Mauritz AB (H&M) and Spain’s Industria de Diseño Textil SA (Inditex), which owns the Zara clothing chain. 

H&M and Zara offer fashionable clothing at inexpensive prices, and they turn over their inventory more rapidly than American competitors such as Gap—thus encouraging shoppers to visit often and buy items that they like on the spot. Both companies have grown their brands by offering what some call “disposable chic” or “fast fashion”—exceptional fashion quality at affordable prices. Both retailers enjoy healthy margins. H&M’s gross margin was 59.5% for its fiscal year ended November 2012, while Inditex’s gross margin was 59.8% in its fiscal year ended January 2013. By comparison, Gap had a gross margin of 39.4% for its fiscal year ended January 2013. 

We have a neutral fundamental outlook for apparel retailers.  We believe the reduction in take-home pay caused by the expiration of the payroll tax holiday benefit on January 1, 2013, will result in some customers cutting back their discretionary spending this year. However, we look for apparel sales to grow 3% to 4% in 2013, supported by new fashion trends and sales promotions. According to the Census Bureau, sales at clothing and clothing accessories stores increased 5.5% in 2012. Apparel retailers face tough comparisons in the first half of 2013, as they benefited last year from an early arrival of spring weather and a new color trend in fashion. We also see increasing competition for share of customer wallet from international retailers expanding in the US. We believe off-price retailers have potential to gain market share in 2013, given their attractive value pricing, frequent inflow of new merchandise, and their ability to move in and out of product categories quickly based on customer demand.

VALUATION ANALYSIS

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DISCLOSURES

Past performance is not necessarily indicative of future results. All investments involve risk including the loss of principal. This report is confidential and may not be distributed without the express written consent of the original author and does not constitute a recommendation, an offer to sell or a solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidential private offering memorandum.

Investments may currently or in the future buy, sell, cover or otherwise change the form of its investment in the companies discussed in this letter for any reason. The author hereby disclaims any duty to provide any updates or changes to the information contained here including, without limitation, the manner or type of any of the investments.

All of the views expressed in this research report accurately reflect the research analysts’ personal views regarding any and all of the subject securities or issuers. The research analyst is not registered with FINRA, and may not be subject to FINRA rule 2711 restrictions on: communicating with the subject company, public appearances, and trading securities held in the research analysts’ account. No part of the analysts’ compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. The analyst responsible for the production of this report certifies that the views expressed herein reflect his or her accurate personal and technical judgment at the moment of publication.

Under no circumstances must this document be considered an offer to buy, sell, subscribe for or trade securities or other instruments.

Disclosure: Analyst(s) covering this company hold shares in ROST.

RECOMMENDATION SCALE

rating
Relevant benchmarks: In North America, the relevant benchmark is the S&P 500 Index
 

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