TJX Should Buy Ross, And So Should You

Apr.24.14 | About: Ross Stores, (ROST)


Ross Stores is trading at a very reasonable valuation given its impressive revenue and earnings growth history.

The discount retailer would be a natural fit in the portfolio of stores operated by the larger competitor TJX.

TJX could use their strong balance sheet to accelerate their own expansion by buying all of Ross Stores while it's on sale.

As an admitted cheapskate, I try to buy things when they're on sale. Whether it's getting my Macklemore on at the local thrift shop, or the weekly trip to Costco (NASDAQ:COST) my wife and I savor along with one of their signature $1.50 hot dogs, I love getting a good deal. I think this frugality serves me well as a value investor as well, prompting me to buy stocks when they get cheaper rather than panic and sell for no other reason than the price is going down.

This economizing ethos makes me appreciate the value proposition offered by Ross Stores (NASDAQ:ROST), both in its Dress for Less stores as well as its stock. This recent article does a good job outlining a compelling case as to why you might consider investing in Ross, so I'll try to avoid repeating much of it and instead focus on what I believe would be a value-creating tie-up between Ross and their larger competitor, The TJX Companies (NYSE:TJX).

TJX offers an array of stores under the Marshalls, HomeGoods, and TJ Maxx banners. The latter is most similar to the Ross Dress for Less concept, offering discount pricing on name brand clothing and accessories, which it is able to do by purchasing inventory directly from the manufacturers; either excess inventory or more consistent purchases made without a buy-back clause.

This allows these stores to attract value but still style conscious consumers like me and my wife by offering an ever changing array of fabulous deals on name brand items. Both TJX and Ross mention this "treasure hunt" strategy in their annual reports, which has also often been referenced by Costco as a successful strategy to keep loyal customers coming back frequently to see what gems they can find.

In fact, it's startling how similar the description of the two companies are in the "Business Overview" sections of their annual reports. Comparing that of Ross to TJX's report, in addition to the "treasure hunt" verbiage, we also find shared reference to "20% to 60% off department and specialty store regular prices" through "opportunistic purchases" from their "expansive/expanding" network of manufacturers and vendors.

Now, a similar business model is not necessarily a justification for a merger, but in the case of Ross and TJX I think it makes sense because of the nature of their operations. A combination would not only further expand the network of manufacturers and vendors that they could choose from, but it would also give them increased purchasing power in cases where there was some overlap.

While the combined entity wouldn't necessarily be the only buyer of last resort to soak up excess manufacturer supply, it would certainly be one of, if not the, largest purchaser of this "off-price" merchandise. As such, we can imagine that it would have significantly increased negotiating leverage, at the very least if only because they're no longer competing against each other.

Just the increase in scale and flexibility to move merchandise around to different stores would also allow the company to more aggressively buy in larger quantities, presumably at larger discounts as well. In addition, the two merchants don't have that much geographic overlap; Ross has current and planned distribution centers primarily in California and South Carolina, neither of which TJX has a distribution location in despite having a much larger presence, especially in Canada and overseas.

Buying Ross would allow TJX to quickly take care of domestic growth so they could focus more attention on expanding into these foreign markets. Again, this makes sense because there is not excessive overlap in the retail store locations either, with TJX most concentrated in the northeast and Ross more focused on the south.

Notably, almost half of all Ross locations are situated in just three states; California, Texas, and Florida, where TJX does not have as many stores despite their larger overall size. These high population growth areas should be able to more easily support both, and even if they have to close some adjacent locations they could target struggling stores and increase same store sales growth at the remaining more desirable locations.

So for all these reasons, I believe an acquisition of Ross by TJX would make a lot of sense, but the question remains whether they would be able to get it done. I can't imagine any anti-trust issues cropping up when even much larger traditional retailers are under so much pressure from online retailing, even though the combination would actually become more resistant to this threat because of increased domination of this niche.

The larger issue would be whether TJX has the financial flexibility to make the deal work, especially after acquiring Sierra Trading Post in late 2012 for $193 million. However, even after this deal TJX still has a very strong balance sheet, with over $2 billion in cash against just over a billion in debt.

Of course, an acquisition of Ross would be much larger, with a market cap of about $15 billion, just over a third of the size of TJX. However, Ross also has a very strong balance sheet with minimal debt, so there would be no need for TJX to assume much debt obligation. Thus, they could easily lever up to complete the purchase and have plenty of cash flow to service the debt, especially if they dial back the billion dollar stock repurchases they have conducted each of the past several years.

If TJX instead focused on buying Ross instead of its own shares, it could actually get an even better deal for shareholders, since Ross trades at slightly lower trailing and forward P/E ratios despite better growth prospects. Even if a buyout premium of 15% were needed to get the deal done, it would be at a similar P/E ratio based on expected earnings for this year.

Plus, the resultant company would likely realize additional cost savings synergies that could further boost earnings growth. Thus, a buyout using TJX stock might be preferable to one financed with debt, since this would allow current Ross shareholders a tax-advantaged way to enjoy instant share price appreciation and the opportunity to benefit from owning a more powerful company in an area they already are clearly comfortable with.

So in conclusion, I feel like Ross Stores is a worthy business to own on its own, especially at today's prices. And it may prove to be an even better deal if TJX comes to a similar conclusion and assembles a discount retail powerhouse through a buyout, so like that great deal you find in one of their stores, I don't feel this sale price will last for long.

Disclosure: I am long COST. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.