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Ross Stores: A Recession Resistant Aristocrat

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About: Ross Stores, Inc. (ROST)
by: Passive Income Pursuit
Passive Income Pursuit
Long only, value, dividend growth investing, long-term horizon
Summary

Ross Stores is a Dividend Champion with 26 consecutive years of dividend growth.  Shares currently yield 0.84%.

Valuing Ross Stores using dividend yield theory and a minimum acceptable rate of return analysis.

Ross Stores is a consistent grower with room to run.

Ross Stores (NASDAQ:<a href='https://seekingalpha.com/symbol/ROST' title='Ross Stores, Inc.'>ROST</a>) Dividend Stock Analysis Passive Income Pursuit

Many words have been written regarding the death of brick and mortar retail due to Amazon (AMZN). While that may be true for some retailers, others with targeted niches have done well for themselves. Businesses like Costco (COST), Walmart (WMT), and Target (TGT) have done just fine over the last decade and I believe that Ross Stores (ROST) falls into that same boat.

Ross Stores sells discount apparel and home goods through the Ross Dress For Less and dd's Discounts stores. The value add for consumers is that they are paying significantly less than department stores for essentially the same goods.

Dividend History

My primary investment strategy is to identify quality companies with a history of paying and growing their dividends payments that I believe will continue to do so in the future.

Ross Stores (<a href='https://seekingalpha.com/symbol/ROST' title='Ross Stores, Inc.'>ROST</a>) Dividend History

Image by author; data source Ross Stores SEC filings

*An interactive version of this chart is available here.

Every year starting in 1995 Ross Stores has been rewarding shareholders with higher dividend payments. That's 26 consecutive years of dividend increases which gives them the title of Dividend Champion.

Ross hasn't been miserly in their dividend growth either with the year-over-year dividend growth ranging from 11.7% to 118.9%. The average 1-year growth rate is 32.6% with the median 1-year growth rate of 24.7%.

Expanding the time frame out to the 21 rolling 5-year periods and dividend growth is equally impressive. Annualized dividend growth over all 5-year periods since their streak began has ranged from 18.0% to 57.5% with an average of 31.5% and a median of 28.0%.

Last year's dividend increase came in at just 13.3% and that was one of the lowest growth rates Ross has provided during their streak. Historically speaking, Ross Stores has been an excellent dividend grower.

The 1-, 3-, 5- and 10-year rolling dividend growth rates since 1994 can be found in the following table.

Year Annual Dividend 1 Year DGR 3 Year DGR 5 Year DGR 10 Year DGR
1994 $0.0012
1995 $0.0018 52.08%
1996 $0.0021 16.44%
1997 $0.0027 24.71% 30.22%
1998 $0.0058 118.87% 47.02%
1999 $0.0079 35.34% 54.59% 45.59%
2000 $0.0138 75.16% 73.12% 49.76%
2001 $0.0206 49.82% 52.57% 57.51%
2002 $0.0230 11.65% 43.09% 54.06%
2003 $0.0275 19.57% 25.99% 36.52%
2004 $0.0390 41.82% 23.71% 37.80% 41.64%
2005 $0.0481 23.33% 27.88% 28.46% 38.70%
2006 $0.0600 24.74% 29.70% 23.84% 39.66%
2007 $0.0714 19.00% 22.33% 25.43% 39.01%
2008 $0.0902 26.33% 23.32% 26.82% 31.58%
2009 $0.1338 48.34% 30.65% 27.96% 32.79%
2010 $0.1600 19.58% 30.86% 27.17% 27.81%
2011 $0.2200 37.50% 34.61% 29.67% 26.72%
2012 $0.2800 27.27% 27.91% 31.43% 28.39%
2013 $0.3400 21.43% 28.56% 30.39% 28.59%
2014 $0.4000 17.65% 22.05% 24.49% 26.21%
2015 $0.4700 17.50% 18.84% 24.05% 25.60%
2016 $0.5400 14.89% 16.67% 19.67% 24.57%
2017 $0.6400 18.52% 16.96% 17.98% 24.52%
2018 $0.9000 40.63% 24.18% 21.49% 25.86%
2019 $1.0200 13.33% 23.61% 20.59% 22.52%

Table and calculations by author; data source Ross Stores Investor Relations

*An interactive chart of the information presented in the table can be found here.

Companies have two ways to grow their dividend: (1) growth of the underlying business and (2) increase their payout ratio. The most sustainable growth is to see growth of the business support a higher dividend. Growth through a rising payout ratio will eventually lead to the risk of a dividend being cut if management is too aggressive and the business goes through a rough patch.

Ross Stores (<a href='https://seekingalpha.com/symbol/ROST' title='Ross Stores, Inc.'>ROST</a>) Dividend Payout Ratios Image by author; data source Ross Stores SEC filings

Ross Stores' payout ratio has been climbing over the last decade; however, it's nowhere near levels to be concerned about. Over the last decade, the payout ratio based on net income has averaged 17.1% and for the TTM period it sits at 22.0%. The free cash flow payout ratio has averaged 20.3% and sits at 24.0% for the TTM period.

Quantitative Quality

My investment strategy revolves around investing in businesses that I believe have a moat around their business as well as a history of paying and growing their dividend payments to shareholders. One of the ways that I use to identify if the first goal is being met is to look at the financials to determine the quality and strength of the business.

Ross Stores (<a href='https://seekingalpha.com/symbol/ROST' title='Ross Stores, Inc.'>ROST</a>) Revenue Operating and Free Cash FlowImage by author; data source Ross Stores SEC filings

Ross has done an amazing job growing revenues over the last decade. In FY 2009, revenues came to $7.18B and for FY 2018 revenues were $14.98B. The TTM period is showing further growth to $15.73B. In total, revenues have grown by 109% or ~ 8.5% annually over the last decade.

Operating income grew from $0.73B to $2.04B over the same period which represents total growth of 181% or ~12.2% annually. Likewise, cash flow from operations improved from $0.89B to $2.07B representing total growth of 133% or 9.8% annually.

Free cash flow has seen similar gains rising from $0.73B to $1.65B. That's total growth of 126% or ~9.5% annually.

Ross Stores (<a href='https://seekingalpha.com/symbol/ROST' title='Ross Stores, Inc.'>ROST</a>) Cash Flow Margins Image by author; data source Ross Stores SEC filings

With free cash flow outpacing growth in sales, Ross has managed to improve its free cash flow margin over the last decade. The averaged free cash flow margin over the last 10 years is 7.6% and for the last 5 years it's 8.9%.

I prefer to see a free cash flow margin above 10%; however, that's not a firm threshold as some industries are higher margin than others. Ross has only managed a >10% free cash flow margin twice in the last decade.

My profitability metric of choice is the free cash flow return on invested capital, "FCF ROIC". The FCF ROIC represents the annual cash return that the business is generating based on the capital invested in the business.

Ross Stores (<a href='https://seekingalpha.com/symbol/ROST' title='Ross Stores, Inc.'>ROST</a>) Free Cash Flow Return on Invested Capital Image by author; data source Ross Stores SEC filings

Ross has managed some truly amazing FCF ROIC results. Over the last decade, FCF ROIC has averaged 34.7%, and for the last five years, the average is 36.9%. There's been some significant variance in Ross' FCF ROIC largely due to the pace of growth out of cash flow changing; however, with a minimum level of 21.9%, that's still more than adequate.

I like to invest in businesses that use their cash flows in ways that align with shareholders. That means that the first priority is to re-invest in the business to both maintain and expand with capital expenditures. If there's remaining cash flow, then I expect management to send some of it to owners via dividends. Any remaining cash flow should go to debt reduction, acquisitions, building a cash buffer or share buybacks.

To understand how Ross Stores uses its free cash flow, I calculate three variations of the metric, defined below:

  1. Free Cash Flow, FCF - Operating cash flow less capital expenditures
  2. Free Cash Flow after Dividend, FCFaD - FCF less total cash dividend payments
  3. Free Cash Flow after Dividend and Buybacks, FCFaDB - FCFaD less cash spent on share repurchases

High quality businesses and management teams will show positive FCFaDB in most years. I'm not concerned about any given year being in the red; rather, it's the trend over the longer term that I focus on. A positive FCFaDB means that the business generates ample cash flow from operations to maintain and grow the business, pay out some of the cash profits to owners as well as have the option to improve the balance sheet, make acquisitions or buyback shares.

Ross Stores (<a href='https://seekingalpha.com/symbol/ROST' title='Ross Stores, Inc.'>ROST</a>) Free Cash Flows Image by author; data source Ross Stores SEC filings

As we saw above, Ross Stores has generated positive FCF every year over the last decade. That positive FCF is what has allowed management to return cash to shareholders via dividends.

In total, Ross has generated $8.54B in FCF over the last decade and paid out $1.67B in dividends over that time. Ross Stores has managed positive FCFaD in every year as well.

Management has spent a total of $6.37B on share repurchases over that time. That puts the cumulative FCFaDB at $0.51B. Ross Stores has shown negative FCFaDB in half of the years as well as the TTM period.

Ross Stores (<a href='https://seekingalpha.com/symbol/ROST' title='Ross Stores, Inc.'>ROST</a>) Shares Outstanding Image by author; data source Ross Stores SEC filings

The $6.37B spent on buybacks reduced the share count from 491.7 million in FY 2009 to 368.2 million in FY 2018. That's a total reduction of 25% or ~3.2% annualized over the last decade.

The following table shows the cash used for shareholders which includes capital expenditures, dividends and share repurchases. I've further broken down the cash into the funding source, i.e., whether it is supported by cash flow from the business or other funding was needed.

Ross Stores (<a href='https://seekingalpha.com/symbol/ROST' title='Ross Stores, Inc.'>ROST</a>) Cash For Shareholders Passive Income Pursuit Image by author; data source Ross Stores SEC filings

Despite the five years and the TTM period not having operating cash flow fully support the capital allocation plans from Ross' management, I'm not concerned at all. That's because when you look at this in conjunction with the balance sheet, the other funding source was cash held on the balance sheet as opposed to debt. Management has maintained a positive net debt position, i.e., cash > total debt, every year over the last decade.

As such, Ross Stores' debt to capitalization ratio is very attractive. Over the last decade, it's ranged from 7% to 15% with an average of 11%. With a current net cash position, the debt that is held on the balance is of no worry.

Ross Stores (<a href='https://seekingalpha.com/symbol/ROST' title='Ross Stores, Inc.'>ROST</a>) Debt to Capitalization Image by author; data source Ross Stores SEC filings

Valuation

One method that I use to value a potential investment is the minimum acceptable rate of return, "MARR", analysis. A MARR analysis entails estimating the future earnings and dividends that a business will generate, applying a reasonable expected multiple on those earnings and then determining whether the expected return exceeds your threshold for investment.

Analysts expect Ross Stores to report FY 2019 EPS of $4.57 and FY 2020 EPS of $5.01. They also expect Ross to manage 9.2% annual earnings growth over the next 5 years. I then assumed that Ross could generate 6.0% annual earnings growth for the next 5 years. Dividends are assumed to target a 25% payout ratio.

Historically, market participants have valued Ross' TTM EPS between ~12.5x and 25x. For the MARR analysis, I'll examine returns using multiples that cover that range.

ChartData by YCharts

The following table shows the potential internal rates of return that an investment in Ross Stores could provide if the assumptions laid out above play out. Returns include dividends taken in cash and are calculated assuming a purchase price of $120.72, Friday's closing price. Returns are run through the end of calendar year 2024, "5 Year", and calendar year 2029, "10 Year".

IRR
P/E Level 5 Year 10 Year
25 8.2% 7.9%
22.5 6.0% 6.8%
20 3.6% 5.6%
15 -2.0% 2.8%
12.5 -5.4% 1.1%

Alternatively, I want to know what price I would need to purchase shares in order to generate the returns I desire from my investments. My typical investment threshold is 10%. I will also examine the price targets based on 8%, the earnings growth return, and 11% which includes 25% undervaluation normalizing over 10 years or ~2.3% per annualized.

Purchase Price Targets
10% Return Target 8% Return Target 11% Return Target
P/E Level 5 Year 10 Year 5 Year 10 Year 5 Year 10 Year
25 $113.85 $102.22 $123.97 $121.15 $109.17 $94.05
22.5 $103.02 $93.10 $112.16 $110.24 $98.80 $85.70
20 $92.19 $83.98 $100.34 $99.33 $88.43 $77.34
15 $70.54 $65.73 $76.71 $77.50 $67.68 $60.64
12.5 $59.71 $56.61 $64.89 $66.59 $57.31 $52.29

Additionally, I like to use dividend yield theory as a quick gauge for the current valuation. Dividend yield theory is based on reversion to the mean with the 5-year average dividend yield being a good proxy for the fair value of businesses with a history of paying dividends.

Ross Stores (<a href='https://seekingalpha.com/symbol/ROST' title='Ross Stores, Inc.'>ROST</a>) Dividend Yield Theory Passive Income PursuitImage source by author; data source: Ross Stores Investor Relations and Yahoo Finance.

*An interactive version of this chart is available here.

Shares of Ross Stores currently yield 0.84% with a 5-year average yield of 0.95%. Dividend yield theory suggests a fair value price around $107.

Conclusion

I believe that Ross Stores is one of the better businesses in the retail space with their discount name brand clothing as well as home furnishings. As a discount retailer, Ross is set to benefit from a trade down from the consumer as they try to make their dollars stretch further in the event of a recession.

Couple that with the large potential growth in store count under the namesake Ross Stores brand as well as dd's Discounts stores.

Ross Stores' management is also top notch and takes a conservative approach to growing their footprint. The business carries a net cash position, cash less total debt, and grows the store count through cash flows generated by the business. It's a more measured approach than other consumer facing businesses, but it's one that's served them well.

Dividend yield theory suggests a fair value range for Ross' shares between $97 and $119, implying that shares are on the upper end of fair value with current prices above $120. Of course, Ross is due for another dividend increase to be announced in early March. An increase to $0.28, ~9.8% increase, would push the fair value range to $106 to $130.

My fair value range based on the MARR analysis is $89 to $110 using the earnings growth justified return target of ~8%.

Ross Stores is trading at or near decade highs based on TTM P/E and EV/EBITDA which makes it hard to justify purchasing shares. I would be interested in adding more shares of Ross in the low $110s and preferably <$100. For the time being, I will remain patient and wait for better opportunities.

Disclosure: I am/we are long ROST. 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.

Additional disclosure: I am not a financial professional. Please consult an investment advisor and do your own due diligence prior to investing. Investing involves risks. All thoughts/ideas presented in this article are the opinions of the author and should not be taken as investment advice.