Ross Stores: Management Concerns Holding Equity Up

| About: Ross Stores, (ROST)

Summary

Market expectations are for an improving Adjusted ROA for ROST, but management’s concerns about the sustainability of EPS and margin improvements imply that this may be unwarranted.

ROST is trading at an Adjusted Forward P/E of 21.8x, near the high end of historical valuations.

At these levels, the market is pricing in expectations for an improving Adjusted ROA, from 16.4% in 2016 to 18.8% in 2021, with no Adjusted Asset growth going forward.

Management’s lack of confidence and concerns about lagging performance indicate that market expectations may be too bullish and that near-term equity upside may be limited for ROST.

Performance and Valuation Prime™ Chart

The PVP chart below reflects the real, economic performance and valuation measures of Ross Stores, Inc. (NASDAQ:ROST) after making many major adjustments to the as-reported financials. The four panels explain the company's historical corporate performance and valuation levels plus consensus estimates for forecast years as well as what the market is currently pricing in, in terms of expectations for profitability and growth.

The four panels explain the company's historical corporate performance and valuation levels plus consensus estimates for forecast years as well as what the market is currently pricing in - in terms of expectations for profitability and growth.

The apostrophe after ROA', Asset', V/A', and V/E' is the symbol for "prime" which means "adjusted." These calculations have been modified with comprehensive adjustments to remove as-reported earnings, asset, liability, and cash flow statement inconsistencies and distortions. To better understand the PVP chart and the following discussion, please refer to our guide here.

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ROST has historically seen cyclical Adjusted ROA (ROA'), peaking at 13.2% in 2003, before declining to a low of 8.7% in 2006. Since then, ROA' has gradually improved, reaching new highs in 2011 at 14.3%, and further improved to 16.4% in 2016. Asset' growth has been volatile as well, but has declined over time, declining from peak 18.1% levels in 2004 to 5.4% in 2010, before recovering to 11.9% in 2013. However, it has since tapered off to just 4.7% levels in 2016.

Performance Drivers - Sales, Margins, and Turns

It can be helpful to break down ROA' into its DuPont formula parts, Earnings' Margin and Asset' Turns, which are the cleaned up margins and turns metrics used to calculate ROA'. The chart below details both Earnings' Margin and Asset' Turns historically, to help us better understand the drivers of the firm's profitability and performance.

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ROA' improvement has been driven by improving Earnings' Margin and stable Asset' Turns. Earnings' Margins reached a high of 6.7% in 2003 before declining to a low of 5% in 2006. Margins have steadily risen since then, reaching 9.7% in 2016. Asset' Turns have been stable, ranging at the low end 1.7x-2.0x levels. Sales growth has also been consistently strong, ranging from 5%-18% levels since 2002.

Embedded Expectations Analysis

As investors, understanding what the market is embedding in the stock price in terms of expectations is paramount to making good decisions. Without understanding what the market is pricing in, it is impossible to claim that the market is wrong. We derive market expectations for the firm from valuations and historical performance trends, to give a clearer picture into what the market is projecting for the firm.

ROST is trading at a 21.8x Adjusted Forward P/E (V/E'), near the high end of historical valuations. At these levels, the market is pricing in expectations for an improving ROA', from 16.4% in 2016 to 18.8% in 2021, with no Adjusted Asset (Asset') growth going forward.

Analyst and Management Expectations and Alignment

Analysts' expectations are in line with the market, expecting ROA' to improve from 16.4% in 2016 to 16.8% by 2018, accompanied by 3.0% Asset' growth.

However, our qualitative analysis highlights that management appears concerned about lagging sales performance in their ladies' apparel segment and accessory business. Additionally, they appear concerned about the sustainability of EPS and operating margin improvements.

Valuation Matrix - ROA' and Asset' Growth as Drivers of Valuation

When valuing a company, it is important to consider more than a singular target price, and instead the potential value of a firm at various levels of performance. The below matrix highlights potential overvalued or undervalued prices for ROST at various levels of profitability (in terms of ROA') and growth (Asset' growth.) Prices that are in excess of 10% equity upside are highlighted in black, and prices representing an excess of 10% equity downside are highlighted in red.

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Considering the lack of management's confidence in the sustainability of EPS and margin improvements, and concerns about lagging performance in ladies' and accessories, market expectations may be too bullish and near-term equity upside may be limited for ROST.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Cheska Pablico. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.