Ross Stores (ROST) operates in an attractive off-price retailing segment. The growth in the space has accelerated significantly since 2008 as consumers, who are financially constrained, have found the idea of buying brand name merchandise for 20% to 60% off department store prices appealing. Moreover, many main line apparel department stores encountered trouble during the financial crises, which allowed Ross to capitalize by increasing its purchasing power as the department stores were left with too much inventory. The question is whether this trend can continue in the future or as the economy potentially stabilizes the growth that Ross has enjoyed slows. It is my opinion that although the pace of growth that Ross has enjoyed form 2008 to 2012 will slow to an extent, the company still has ample growth opportunities and the stock price, which is currently at a reasonable valuation, should drive above-average returns over a 3 to 5 year period.
Off-Price Retailing Industry
The growth that Ross Stores has seen since 2008 is not unique. The total aggregate sales for the top 5 retailers in the sector grew 11% in 2012 on top of a 6% increase in 2011, and a 9% increase in 2010, compared with a 4% increase for total national apparel according to NPD group. Ross has been among the fastest growing publicly traded companies in this fast growing industry and has higher growth prospects in my opinion than its larger competitor TJ Maxx. In my opinion the value proposition of off-price retailing is still attractive in this economy in which consumers still have a more frugal mindset than in the past due to the financial crisis. I believe this will be an ongoing trend and will allow the off-price retailer to continue to take market share. Part of the allure of off-price retailing is the "treasure hunt" shopping experience. The retail format is fairly open by design and the merchandise is constantly changing, so it encourages shoppers to hunt for an item and repeat visits.
New Store Potential
Ross Stores had 1091 stores in 33 states and 108 dd's DISCOUNTS in eight states at the end of 2012. dd's DISCOUNTS was acquired by Ross Stores in 2004 and has a different demographic than the typical Ross Store with a younger lower income consumer. Ross Stores management announced in May of 2013, that it plans on increasing the total store count to 2500, with 2000 stores consisting of Ross Stores and 500 being dd's DISCOUNTS. In 2011 Ross resumed its expansionary efforts into different states, which it had not done since 2007. Moreover, Ross Stores increased its square footage by 5.0% in 2012 compared to a 3.2% CAGR from 2011 to 2008.
Ross Stores EBIT margins have expanded dramatically since 2006 largely due to higher merchandise margins and operating leverage from relatively robust same-store comps. Ross Stores has made it a priority to drive sales with lower inventory levels, which has resulted in lower merchandise markdowns.
Ross Stores EBIT margins are highly correlated to same-store sales, so same-store comp performance largely determines the extent of Ross's ability to generate expense leverage. However, even though same-store comp performance has been the main driver of margin expansion Ross has been very effective in varying SG&A levels depending on sales performance. Ross has been able to maintain margins or expand margins in light of weaker comps. In the first quarter of 2013 Ross posted a 3% increase in same-store comp and EBIT margin expanded 14.9% from 14.4% year over year. The trend of gross margin expansion continued in 2013 as gross margins expanded from 28.8% to 29.2% year over year highlighted by 50 basis points improvement of merchandise margins and 5 basis points improvement of shrink expense. Management has stated on conference calls that it believes between a 2% or 3% increase in same-store comp is needed to generate expense leverage. Management has a history of being very conservative in its guidance estimates and I believe that Ross Stores can generate margin expansion at a 2% increase in same-store comp level going forward, due to leaner inventories and effective expense control.
In addition to aggressively but prudently investing in new store growth Ross Stores is building a new distribution center in 2013 and 2014 to support its accelerated growth. Next, Ross Stores deploys all of the free cash flow every year into buybacks and dividends. It has a consistent record of increasing the dividend every year since 1994 and has repurchased stock from 1993. Currently the dividend yield is 1% and the free cash flow yield is 3.9%, so the bulk of the free cash flow is deployed into buybacks. The diluted share count decreased from 309.96 million in 2002 to 220.02 million in 2012, which amounts to an annual reduction rate of 3.4% for the last 10 years.
The main assumptions for my EPS growth model is that Ross Stores can grow its store base at a 7% square footage clip as Ross Stores is accelerating the store count to grow at 6.5% this year and it continues to increase the growth until it peaks at 7.5% in 2015 and average at 7% during the period. Ross should continue to gain share, but the same-store comps decelerate to an average of 3% over the next 5 years. The comps over the 5 years have been high and it is unlikely that Ross can comp at such a high level in the long term. It will be harder for Ross to produce the same level of same-store comp growth that it did from 2009 to 2012 as it accelerates store growth. Ross can potentially lever a 2% comp, which will generate EBIT margin expansion. EBIT margins should expand approximately 150 to 14.6% at the end of 2017, in my base case model. That base-case scenario produces a 5-year CAGR EBIT of 12.4% on top of an annual share count reduction of 2.9% and results in a 5-year EPS CAGR of 15.8%.
This is higher than the sell-side estimate of 11.92% EPS growth for the next 5 years and above management's target of 5-year growth of 10 to 15% EPS growth. Management is notoriously conservative in its targets and its estimates when observing the historical trends. It perpetually likes to guide low and proceed to beat estimates by a considerable margin. It would not surprise me if it provides a positive surprise again.
Ross Stores' free cash flow yield is 3.9% currently, its trailing P/E is 18.12, and the forward P/E sell-side consensus is 15.12, and its EV/EBIDTA is 9.25. The trailing P/E ratio for TJ Maxx is 19.55 with an EV/EBIDTA of 9.72, despite the fact that it has a much more mature store base and its growth prospects are not as high Ross. TJ Maxx same-store comps are approximately the same and are currently running a bit below Ross' with an EBIT margin of 12% compared with Ross Stores' EBIT margin of 13.2%. The PEG for Ross incorporating my base-case growth estimates and incorporating the dividend yield equates to 1.08. The average trailing P/E for Ross for the last 4 years has been 19.1. Ross' current multiple seems to be justified.
Trade Up Risk
A main risk for Ross is that the if the economy recovers and consumer sentiment rises, consumers would be inclined to move away from an off-price retailer like Ross as the economy improves to more expensive department stores. I believe this may occur to an extent, but will not be particularly material for a number of reasons. One reason why I believe that the trade up risk will not occur to a significant extent is there has been a fundamental shift in consumer behavior patterns away from department stores in which mall-based retailers have been losing share and that is unlikely to reverse in my opinion. Retailers located in strip malls have seen more growth than those in large malls as vacancy rates at many traditional older malls are much higher than strip malls.
Another reason is that the off- price retailing model in which customers can buy brand name apparel for significantly less than at main line department stores could potentially hold a certain amount of appeal to consumers even in a stronger economy. Even though consumer sentiment has been on the mend, there has not been significant deceleration in Ross Stores' business. Ross Stores posted a robust same-store 5% comp increase in the fourth quarter of 2012, and a respectable same-store 3% increase comp in the first quarter of 2013, compared with a strong 9% increase in the same-store comp in the first quarter of 2012.
The trade down effect has greatly benefited Ross Stores and in my opinion the company will continue the momentum that began in 2008. Management's focus on strong cost controls combined with a shareholder friendly capital allocation system should further bolster the company's prospects. The valuation is fair in light of Ross' bright future and above-average growth prospects should drive above-average returns over a 3- to 5-year time horizon.
Disclaimer: I make a number of forward looking statements and actual outcomes can differ materially from projections. The projections are subject to risks and uncertainties. This article is my opinion and should be taken into context with all relevant information when making an investment decision.