- Ross Stores posted a great 2019, but provided muted guidance for comps and EPS growth in 2020.
- Coronavirus is easily my biggest fear, but I think it will be contained faster than the consensus may think.
- Shares look somewhat cheap, and they are worth $116-122.
Shares of Ross Stores (NASDAQ:ROST) tumbled after hours, falling to $105.70 after opening the day at $111. The company posted Q4 results that were slightly better than anticipated, and, as per their standard practice, guided to muted comp store sales growth of 1-2%, scaring off nervous investors. I realized that I have not written about Ross Stores since 2018, though I have happily held shares in the interim. Let’s take a look at the fundamentals of the business after it reported 2019 results, and why I believe shares are slightly undervalued, worth $116 - $122.
Q4 and 2019 – Solid Performance Consistent with Past Trends
Ross’ Q4 results were relatively consistent with what one would expect from the company. Sales jumped 7.5% y/y to $4.4 billion driven by an impressive 4% comp store growth rate against a 4% growth rate in the year ago period, driving a 2-year stack of 8%. Results were similarly strong for FY19, with total sales up 7% y/y to $16 billion driven by a 3% comp against a 4% comp for 2018. Ross’ model continues to work, with strength specifically in the children’s business as well as the Midwest driving results in Q4.
On the cost side, gross margin for FY19 fell about 30 basis points y/y to 28.1% of sales, driven largely by higher distribution costs as well as tariffs in China. SG&A declined about 10 basis points y/y as the company was able to achieve some comp store growth leverage in spite of a higher wage environment. Ross always manages SG&A costs tremendously well, and it should be little surprise that management contained operating margin erosion to 20 basis points in FY19, with operating margin coming in at 13.4%, with some strength shown in Q4. Management runs the business incredibly tight, and I think the company has successfully mitigated significant wage pressure by taking out cost elsewhere.
Overall, EPS was up 8% y/y in 2019 to $4.60 per share, with net income growth bolstered by the company’s decision to reduce the share count by roughly 3%.
When it comes to share count reduction, few companies execute better than Ross. Frequent leaders will be familiar with my annoyance at buybacks that are basically executive compensation offsets, which is exactly why Warren Buffett has always considered stock-based comp a real economic cost. Ross is a true repurchase machine. From the end of FY10 until the end of FY19, the company has bought back 143 million shares, reducing the share count by 28.6%, spending a whopping $7.7 billion on share repurchases. This is one of the primary reasons why I think Ross has trounced the market over the last decade, returning nearly 8.75x for shareholders versus 2.4x for the S&P 500 with dividends.
On the capex front, Ross increased its store count by about 5%, adding 88 net new stores, about in-line with Ross’ guidance of opening roughly 100 stores per year against roughly 10 closures or relocations. Ultimately, Ross spent $555.5 million on capex compared to $413.8 million in 2018. This huge jump in capex spending more than offset the growth in operating cash flow, leading free cash flow fall about 2% y/y. However, excluding working capital changes, which can be transient and immaterial in nature, free cash flow grew 4.8% y/y, more in-line with the trajectory of the business. Some noise from income tax changes and a change in operating lease assets and liabilities caused a few minor puts and take, but ultimately, growth in operating cash flow was strong.
On an adjusted capital basis, I estimate the company returned around roughly 28% versus 26% returns in 2018. In short, all signs point to a healthy business with fantastic returns on capital.
Similarly, the company grew its payout again, increasing its quarterly dividend by 12% to $0.285 per share, equating to an annual yield just shy of 1.1%. Although I’m typically a much bigger fan of dividends, I think the increase in dividend signals increased confidence in the future. This capital allocation strategy has yet to be proven wrong for TJ Maxx (TJX) or Ross over the past decade.
Why Exactly Did it Sell Off?
Management must love the opportunity to get shares at a lower price virtually every time they spoke investors, guiding for below consensus comp growth and EPS growth. The company essentially noted comps would be up 1-2% and EPS would grow 1.5-6.1% y/y. This is particularly frustrating, as it implies net income will fall, with buybacks accounting for the balance. Certainly, it makes sense to provide conservative guidance with a global pandemic spooking consumer across the globe and disrupting the global supply chain, potentially making more customers want to interact with the web for apparel.
That being said, I think we will need to see how containment efforts evolve for the Coronavirus. Companies are apt to create travel bans for overseas travel as well as domestic travel, and I think this sort of signaling behavior will drive more people to fear the virus and opt to stay at home. In reading about the likely underreporting of mild/asymptomatic cases in China and the relative standard of care and availability in China, I think the current estimate of being 2.3% deadly is too high, and I think the world may normalize faster than anticipated.
Nevertheless, 2020 is probably a bit uncertain, but I would bet heavily on Coronavirus incidence rates being lower in Western societies than China. I also believe the complexity of the viral strand and the sudden need to vaccinate the world could compel big pharma to move at ultralight speed.
Regardless, the point here is that the company is down on some macro noise, 2020 may be tough, but I think the stock is worth $116-122. I suspect we will see some pent-up demand throughout 2021 offset some weakness in 2020 spending. I am long shares, and I am likely to add to my position in the next few days.
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Analyst’s Disclosure: I am/we are long ROST, TJX. 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.
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