The Long Case for Ross Stores - Part I

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 |  About: Ross Stores, Inc. (ROST)
by: Margin of Safety Investing

In this analysis, I am looking at Ross Stores (NASDAQ:ROST) as a long investment opportunity. A quick review of ROST’s financials attracted me to the company:

  • Good cash flow generation

  • High returns on equity and assets, especially for a retailer,

  • Limited dividends/buybacks but a good potential for intrinsic returns

  • Strong Balance Sheet with almost no debt

  • Relatively low valuation on a cash return and P/E basis

The analysis will first evaluate the company’s performance which in turns informs a discounted Free Cash Flow model, coupled with the determination of a reasonable margin of safety and likely intrinsic returns of the company.

Company overview

Ross stores is the second largest off-price retailer of brand name apparel and home accessories in the U.S. with FY 2009 sales of $7.2 billion. The company runs 979 Ross Dress for Less stores in 27 states and 57 Dd’s Discounts in California, Texas, Florida, Nevada and Arizona. Ross offers merchandise at ~20%-60% off the regular price. Dd’s discounts does the same with lower tier brands at prices that are another 20% lower vs. Ross store prices.

Ross’ focus on building out its store base and improving merchandise assortment in its key categories (accessories, home goods and apparel) has served it well both in recent quarters- given the “belt tightening environment”- as well as over the long term. The company has improved revenues 28 years in a row as of the end of FY 2009. This length of “success” underscores that both have two important assets: A repeat customer and deep relationship with key apparel manufacturers. Ross' “typical customer” is a woman (75% - 80%) with a wide range of household income (Ross customers “want a bargain” more than they “need a bargain”) who comes to the stores 3 times per month.

Ross (as well as the industry leader TJX) has clearly benefited recently from the economic environment:

  • Sales increased 11% during FY 2009 (ended Jan 2010) including 6% same store growth

  • Sales increased another 11% during the first semester to July 2010, including 7% same store growth.

Management believes that the company has still some potential for growth, citing a potential for up to 1,500 Ross Dress for Less stores and another 500 Dd’s stores. In the short term, the company is planning to add another 50 stores during 2010 and is planning on ~70-80 in 2011. Note that while this will add to revenue growth in the long term it could be a bit of a strain on Free Cash Flow in the short term.

Profitability and Growth

ROST’s revenue growth has been both fairly high and consistent with averages of 9.7% and 9.4% over the last 3 and 5 years, respectively. On a year over year basis over the last 10 years, ROST had consistent annual growth rates in the 7%-12% range with a couple spikes in 2006 and 2003.

In addition to growing, ROST has been able to perform well on the margin front. Gross margin came down with growth between 2001 and 2006, from 30%+ to 22.5%. Since then, margins have been improving back, reaching 26.7% on a TTM basis. As a result, Operating Income, Operating Cash Flow, Free Cash Flow (FCF) and EPS have grown at high rates (>10%) over the last 10 years, even accelerating to 30% p.a. or more for some of these metrics.

$ millions, except per share data

Growth Rates

2006

2007

2008

2009

2010

TTM

3-yr

5-yr

10-yr

Revenue

4,944

5,570

5,975

6,486

7,184

7,571

9.7%

9.4%

11.6%

Op. Income

325

390

421

495

719

842

30.7%

20.0%

9.8%

Net Income

200

242

261

305

443

519

30.3%

20.0%

10.2%

OCF

375

507

354

583

888

779

58.4%

20.5%

16.0%

FCF

199

283

117

359

730

614

150%

32.8%

18.0%

EPS

1.36

1.70

1.91

2.33

3.54

4.29

36.4%

24.9%

13.7%

Note: Growth rates calculated using log-normal regression and exclude LTM

Click to enlarge

Looking forward, I will be using a growth rate of “only” 8% over the next 5 years, which is slightly below historical revenue performance of 9-10% on average over the last 5 years, but still within some of the annual growth rates that have been seen by the company in the past. This is also more conservative than analyst consensus of ~13.9%.

Turning to cash flow and evaluating a “starting point” for our disounted cash flow (DCF) below is more challenging as FCF has been volatile from year to years as the table above illustrates over the last 5 years – to put it numerically, ROST’ FCF’s standard deviation vs. regression has been almost 60% over the last 10 years. One way to approach this approximation is to start with Operating cash flow which has been somewhat less volatile than FCF (standard deviation of 22%). A regression of OCF over the last 10 years gives us a “starting” OCF of ~$800M. From that we can then deduct the $200M Capex expense that the company is planning for next year and arrive at a starting FCF for our DCF of $600M.

Turning to returns, ROST’s performance has been strong with ROE’s [return on equity] and ROA’s [return on assets] of 29% and 12% on average over the last 5 years, respectively. The ROA is a bit low for my taste (cf. my stated goals when reviewing a company) but in the retail industry with thin margins and high turnover I consider the ROE to be impressive and ROA to be more than acceptable. While ROE and ROA’s have been better in the last few years, I will be using the average of 29% for return on equity going forward as an input to the sustainable growth rate calculations.

Based on ROST’s strong returns for its industry, good revenue growth driven both by same store sales as well as geographical expansion and good cash generation, I believe that ROST has a business moat. However FCF has been somewhat volatile in large part due to Capex swings. This suggests that I should be using a higher margin of safety than the 25-30% I would use for a strong stable business. I will use 40% as a margin of safety in order to evaluate the attractiveness of the stock.

Part 2 will cover financial health, use of cash, intrinsic returns and valuation.

Disclosure: Long Rost