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Shop ’til You Drop: Another Holiday Bargain?

By Ari Charney on December 24, 2012

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By now, you’re probably so exhausted from holiday shopping that you’re loath to contemplate anything that has to do with retail. Nevertheless, I’ve continued my search for companies whose management teams not only have their interests aligned with shareholders, but also generate high returns on invested capital.

That led me to Ross Stores (NSDQ: ROST), the off-price retailer whose core demographic may be low- and middle-income consumers, but whose steep discounts (20 percent to 60 percent) on name brands also appeal to those with more disposable income to burn. The company does business primarily as Ross Dress for Less, though it’s also ramping up its dd’s Discounts stores.

Because a number of fund managers I’ve interviewed take upward earnings revisions into account as part of their initial screen, I decided to layer that into my usual search criteria. After all, I’ve learned the hard way that a stock that seems to offer a compelling value can languish there far longer than I anticipated. So I’m keenly interested in ways to determine whether a beaten-down name is about to reverse its slide.

To that end, I’ve been looking at near-term relative strength as part of this approach, but I still prefer to go with the fundamentals. Therefore, it’s presumably meaningful when the Wall Street analysts who spend their time focusing on both the company and the industry are raising their expectations of future performance.

In the case of Ross, according to Bloomberg, seven analysts revised their adjusted earnings forecasts higher over the past three months, while two of the 26 analysts who track the firm upgraded their ratings to buy over the past month.

That sounds promising, but it’s important to note that the stock is down almost 24 percent from its 52-week high of $70.82 per share set back in late August. Even so, Ross is still up 14.6 percent year to date.

After an enviable run this year, the retail apparel industry has also fallen harder than the market over the past three months, tumbling 6.1 percent compared to the S&P 500′s 1.4 percent loss. But clearly only some of the weakness in Ross’ shares can be explained by sector woes.

Ross Shares for Less

It looks like a number of funds and institutions pared their holdings around the time Ross was trading near its high earlier this year. For instance, Fidelity Low-Priced Stock (FLPSX) sold 2.5 million shares, or 20 percent of its holdings in the stock, some time during the quarter ended July 31. However, the small- and mid-cap fund still retained a sizable stake in the stock, roughly 10 million shares, or 4.4 percent of the firm’s total shares outstanding.

But the stock started to head lower in earnest during October and November. It appears this action was precipitated due to concern about flagging same-store sales. In early October, management reported same-store sales growth of 5 percent for the prior month, which soundly beat analyst expectations. But its forecast of 3 percent to 4 percent growth for October was far more modest by comparison.

In early November, the company revised its third-quarter earnings guidance slightly higher, but at the same time announced growth in same-store sales for October that lagged analyst expectations–sales in stores open for at least a year grew 4 percent versus consensus expectations of 4.6 percent.

Meanwhile, the company also faces a potential political headwind. Should Congress fail to avert the so-called “fiscal cliff,” taxes will likely rise across the board for most Americans, which could reduce the disposable income of the company’s lower-income shoppers.

Impervious to Fickle Fashion Trends (and Recessions)

On the other hand, Ross tends to perform well during periods of economic turmoil, as consumers shift their spending from higher-end stores to discounted fare. And our nation’s present malaise has only given faint signs of finally lifting. While Ross could lose sales from some of its existing shoppers if their budgets get pinched by tax increases, similar considerations could compel households with slightly higher incomes to finally trade down to Ross.

And while one should never extrapolate from anecdotal evidence, I must confess that my family as well as a handful of our peers, who would hardly be considered the store’s core constituency, regularly browse Ross for bargains. Indeed, their praise for the store’s discounted wares is effusive, even though the actual shopping experience there is akin to a chaotic street fair.

Though I’m typically leery of apparel retailers as investments due to ever-changing trends, Ross insulates itself from such risk by buying a broad array of branded overstock, without overcommitting to any particular inventory.

The company typically buys packaway inventory at the end of a season and stores it for a couple quarters before selling it. Ross’ 500 buyers have existing relationships with about 8,000 vendors and pursue a flexible strategy that ensures selection is broad, but not deep.

So when shoppers finally happen upon coveted brand-name apparel that suits their aesthetic, the lack of excess stock means the piece has the allure of being a unique find, which makes it difficult to walk away without purchasing it. Finally, fashion at this level doesn’t tend to change dramatically from season to season.

But It’s Really All About the Fundamentals

But the main reason to consider Ross is its impressive fundamentals. The company’s return on invested capital (ROIC) has averaged nearly 38 percent over the past five years and is projected to continue tracking above 20 percent for the foreseeable future. And ROIC has exceeded its weighted average cost of capital by 1.8 times, which shows management is skillfully allocating capital.

Sales have risen 11 percent annually during the past decade, while earnings per share have grown almost 20 percent annualized over that same period.

Analysts expect Ross to post full-year earnings growth of 22.4 percent year over year once the company reports for the final quarter of its fiscal-year 2013 ending in January. Thereafter, earnings are expected to decelerate, though the consensus for fiscal-year 2014 is still a respectable 11.1 percent rise in profits.

The company boasts a strong balance sheet with $625 million in cash at the end of the third quarter and just $150 million in long-term debt.

Ross is significantly smaller than competitor TJX Companies (NYSE: TJX), which does business primarily as T.J. Maxx and Marshalls. While Ross has over 1,200 stores nationwide, TJX operates about 2,900 stores globally. That means Ross has further room to grow relative to the more mature TJX.

Indeed, management hopes to eventually have 2,500 stores in operation by the end of the decade. And the good news is that Ross can encroach upon TJX’s geographic footprint without necessarily engaging in head-to-head competition–TJX tends to cater to a slightly wealthier demographic.

A Value Proposition

Aside from future growth prospects, Ross also offers a more compelling valuation than TJX. Its forward price-to-earnings (P/E) ratio is 13.5 versus 14.9 for TJX. Also, its price-to-book ratio (P/B) is 7, compared to 8.9 for TJX. And while shares of TJX trade at a 10.5 percent premium to Morningstar’s estimate of the stock’s intrinsic value, Ross’ shares trade at a 15.6 percent discount to fair value.

And those investors anxious about the possibility of another economic downturn may find solace in Ross’ recession-resistant stock. Its shares gained 17.8 percent in the bear market year of 2008 versus the market’s 37 percent loss. Even better, the stock has returned more than 18 percent annually over the past 10 years, trouncing the market’s nearly 7 percent annual gain.

Corporate insiders own 3 percent of shares outstanding, which is hardly insubstantial, though it would be more reassuring to see them add to their positions during the stock’s recent weakness. However, none of this year’s selling activity occurred during the stock’s recent drop.

Ross is in the midst of a robust share repurchase program, with a two-year authorization to buy back $900 million worth of stock. The company repurchased $335 million of stock year to date, which reduced diluted shares outstanding by 3 percent.

Unfortunately, management did spend about $251 million to buy shares at an average price of $68.57, just shy of the stock’s high in August. But they still had almost $116 million of the authorization remaining at the end of the third quarter to take advantage of the stock’s recent swoon.

As the company grows, its $0.14 quarterly dividend (recently yielding 1 percent) should also head higher. The company’s payout ratio is just 16.4 percent, and management has boosted the dividend every year since 1994.

Ross generates substantial free cash flows–$612 million over the trailing year–which, in addition to both the dividend and the aforementioned buyback program, it will likely use to fund more store openings.

Although Ross appears to offer a solid value, caution is still warranted until its downside momentum abates. Investors should slowly build a full position in one-third increments while the stock finds a near-term bottom.

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Stock Talk

  1. avatar
    Nir Eyal Reply February 14, 2013 at 6:28 PM EDT

    Thank you Ari.
    What’s the evidence that Ross does this? Do you know of any sources online that show that Ross is better at the “treasure hunt” than others?
    I’m working on a story and would love to chat more about this? Can you email me so we can discuss offline? I’m at nir @ nireyal dot com
    Thank you and great article!

  2. avatar
    Nir Eyal Reply February 14, 2013 at 1:40 PM EDT

    Thanks Ari – you said: “when shoppers finally happen upon coveted brand-name apparel that suits their aesthetic, the lack of excess stock means the piece has the allure of being a unique find, which makes it difficult to walk away without purchasing it.”
    Do you think the company’s “treasure hunt” strategy is unique? Isn’t this something many retailers do?

    • Ari Charney
      Ari Charney Reply February 14, 2013 at 5:01 PM EDT

      It’s unique relative to its competitors in the off-price retailing space, which tend to purchase deeper inventory and therefore stock more of a particular piece than Ross does.

      Best regards,
      Ari

      • avatar
        Nir Eyal Reply February 15, 2013 at 1:27 PM EDT

        Hi Ari – Would love to see any citations that say this is so. Can you point me to any sources? Thanks!