Ross Stores: Don't Get Carried Away By Growth

Summary

• We summarize ROST's Q3 2018 earnings release and the key takeaways.
• New store openings and other market share gains are offset by declining margins.
• Online is the trend, but ROST hasn't logged on.
• Valuation is already pricing in the positives.

Though Ross Stores' (NASDAQ:ROST) sales have increased 6.6% Y-o-Y while comparable sales growth has come in at 3% (beating consensus estimate of 2.8%), there are a few headwinds to watch out for. Operating margins have declined by 90 basis points Y-o-Y, now down to 12.4% from 13.3% in 3Q2017. The main reason for this decline was the increased COGS thanks to a rise in freight cost and an increase in SG&A expenses due to a rise in wage costs. Ross Stores recently rolled out wage increases across its stores, so margins could continue to remain under pressure.

Additionally, competition in the off-price retail sector is fierce and any attempts by competitors to gain additional market share by lowering prices could hit margins for the entire industry. The lack of an online presence also hurts Ross. Hence, this may not be a good time to buy the stock.

New store openings and other market share gains

Wage increases and departmental store closures are tailwinds for off-price retailers as they are key factors driving market share gains available from those closed stores. Brands are also looking to sell their inventory through alternate channels to make up for those store closures. Ross has benefited from this industry level trend and has managed to open 40 new stores in 3Q2018. In fact, it has now opened 75 Ross stores and 25 Discount DD stores in fiscal 2018. Buoyed by its performance, Ross has upgraded its long-term store target to 3000 from 2500 earlier.

The new store growth and comps growth of 3% has led to sales growth of 6.6% Y-o-Y. Ross has been on a consistent growth trajectory, having completed its 10th consecutive quarter where earnings have beaten estimates.

	Q3 2018
Key Metrics (USD, billions)	Actual	Consensus
Sales	3.55	3.56
Gross Margin (%)	28.2	28.5
Comps growth (%)	3	2.8
Operating Margin (%)	12.4	12.4
EPS	0.91	0.9

Click to enlarge

Source: FactSet

However...

There are some issues that paint a different story for the future. Margins have deteriorated to 12.4% from over 14% in 2017. The main reason for this fall in margins was attributed to more expensive COGS (60 basis points higher), higher freight costs (50 basis points higher), and an increase in distribution/buying expenses (15 basis points higher). The higher freight costs are expected to remain high in the near term as suggested by management in their earnings call. Wage expenses are also expected to remain high because management has rolled out a wage increase program across its stores.

There is a limit to how much SG&A expenses can be cut, even after incorporating efficiencies and process improvements. With a fairly inflexible SG&A, comps growth will then be the key factor that can keep margins stable. If comp growth does not happen as expected, then margins can contract significantly. In recent times, average unit retail (AUR) has also remained flat while an increase in units per transaction (UPT) has driven comp growth.

Online is the big trend in retail, but has Ross logged on?

Ross has no online presence. Per UBS analysts, online sales penetration for North America is estimated to rise to 31% by FY2022 (vs ~23% in 2018). Ross stands to lose out from that shift without any online store, as some of its customers are bound to migrate towards e-commerce. If Ross does decide to have an online presence, then setting that up will likely affect margins in the near to mid-term. Setting up online and driving customers will cost significant money, especially since Ross has not had online over all these years and has to catch up.

With the majority of its investments having gone towards new stores until now, a shift in the investment towards online could slow down new store growth as well. Almost half of Ross's sales growth comes from new store openings, so sales growth will be affected significantly if new store openings slow down.

Valuation already seems to be pricing in the positives

Ross is currently valued at about 22x earnings. Comparing that ratio with Gap (GPS) at 11x, L Brands (LB) at 10x, and TJX Companies (TJX) at 19x, it seems as if the stock isn't cheap by any means. The positives such as consistent earnings growth, dividend payouts, share buybacks, and high brand value created by offering low price apparel to value-seeking customers all seem to be already built into the current valuation that the market is giving Ross.

Some other structural risks

Competition

Ross faces competition from multiple sources in a highly fragmented retail apparel market. There are department stores, specialty stores, warehouses stores, discount stores, manufacturer-owned stores, and other off-price retailers (like Ross) who are all vying for market share in a crowded industry. Many of these competitors have bigger brand names, larger presence, more store locations, and significant financial resources to fight out the competition.

Macro-sensitive client base

Ross's customer base is mainly the middle and lower-middle income value seeking profile. Such a profile tends to be more sensitive to macroeconomic factors like interest rate hikes, fuel price rise, credit growth and availability, unemployment level variation, etc. Since shopping at Ross would be considered as discretionary spending, the company's future prospects are very tightly linked to the macro environment.

Reduced availability of high-quality branded inventory

Ross and other off-price retailers depend heavily on the availability of inventory from high-quality brands. Any shortage of that inventory supply or any shift of that inventory towards e-commerce players can significantly affect Ross's business.

Conclusion

While it may be easy to get carried away with past performance and consistency of Ross, it is difficult to ignore the changing landscape of the off-price retail industry. Ross does not seem to have much room for maneuvering, with margin pressure, fierce competition, and rising costs affecting its business. Valuations already seem to reflect the positives about the company and it is quite possible that the PE multiple may fall to a more reasonable level that would then warrant another look at the stock.

Analyst’s 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.