Description

Prior to the pandemic, Ross Stores (ROST) had been a long-term compounder, producing exceptional equity returns for many years. For the decade ending in 2019, the stock’s annualized total return was over 25%. This return was the result of the company consistently producing solid financial results over an extended period. For example, sales compounded at 8.4% while operating earnings compounded at 12% due to operating leverage. Tax reform and a 3.2% annual reduction in shares outstanding resulted in EPS compounding at 18%. During that time the company grew the store base by 5% to 6% per year and revenues per store grew at 2.2% per year (note, this is not the same as comparable sales as it includes new stores). Every year the company would expand a bit geographically as well as backfill existing geographies, steadily growing over time. Its capital needs (i.e. new stores, distribution centers, technology, working capital) were relatively modest which allowed the company to pay a growing dividend and use all excess cash to retire stock. Capital allocation was essentially set on autopilot: fund internal growth, pay a growing dividend, and return all excess cash in the form of buybacks while maintaining a net cash balance sheet. The overall diluted share count declined by 28% over the past decade ending in 2019. Obviously, HSD revenue growth, LDD growth in operating income, annual reductions in shares outstanding coupled with multiple expansion leads to outstanding performance.

We had admired the stock for a long time but had never bought it because it always seemed too expensive. However, when the pandemic hit in March of 2020 and the stock was nearly cut in half, we bought shares with the idea that things would eventually return to normal and the company’s strong financial position would help it ride out the storm in the meantime. We were right about the company being able to ride out the storm from a financial standpoint. The idea that things would return to “normal” hasn’t quite panned out like we anticipated, at least up until now. However, we believe the return of “normalcy” may be close and we think the stock represents good value at the current price. The remainder of this write-up will summarize Ross Stores, what has happened during the post-pandemic period, and what the returns may look like moving forward.

Ross Stores, Inc. operates two chains of off-price apparel and home goods stores in the US, Ross Dress for Less and dd’s Discounts (collectively Ross). The stores sell branded apparel, footwear, home-related merchandise, gifts and other various items. Primary product categories include home accent/bed & bath (26%), ladies (24%), men’s (15%), accessories/jewelry/cosmetics (14%), shoes (12%) and children’s (9%). Ross Dress for Less is the largest off-price apparel chain in the US with 1,704 stores in 40 states. Approximately 20% of stores are in California and 12% are in Texas and the company has no stores in New England, Michigan, or Minnesota. The company estimates that Ross Dress for Less can ultimately reach 2,900 stores in the US. dd’s Discounts operates 330 stores in 22 states. Management believe dd’s can ultimately grow to 700 stores, bringing the company-wide store total to 3,600. Given the typical growth in net stores of around 90 annually, Ross’s runaway to grow the store base spans over a decade and a half.

The merchandise at Ross Dress for Less is typically priced at a 20% to 70% discount to full retail price and dd’s pricing is a bit less than Ross. The company has estimated that the average household incomes of Ross and dd’s shoppers is $65,000 and $45,000, respectively. Ross and its 900 merchants have relationships with thousands of product vendors and can quickly and efficiently purchase, store, and distribute inventory. dd’s focuses on more modestly priced goods with an emphasis on younger, more urban consumers as compared to Ross Dress for Less. Ross buys from vendors looking to sell surplus items, cancellations, overstocks, incomplete assortments etc. and will pay quickly without return privileges and have the inventory shipped directly to its distribution centers. Ross can be opportunistic with its purchasing decisions given its financial strength and ability to store goods in packaway for several months prior to placing those goods on the selling floor. Packaway inventory has averaged over 40% of total inventory at any given time and is typically stored for three or four months.

Given that Ross’s marketing doesn’t focus on specific brands, vendors can sell excess goods without harming the reputation of the brand by having it publicized as being in the discount channel. Ross has no online presence other than its customers on social media and relies on the “treasure hunt” approach to keep its customers returning to the store an average of three times per month. The inventory in stores will vary by geography and season and inventory turns over quickly which helps reduce fashion risk as well as the need for markdowns. Depending on demand, stores on average receive between three and six shipments per week.

As mentioned above, from a financial standpoint, prior to the pandemic, Ross consistently generated strong financial results. Prior to 2020, the store base increased by 5% to 6% annually and total square footage increased slightly less than that given the growth in dd’s and its smaller format. Comparable sales grew by 3% or 4% annually and had been positive every year between 2004 and 2019. This comparable growth was due to volume and not price as there has been no inflation in apparel in the US for two decades, at least prior to 2020. The highest comparables in Ross’s history were from 2009 through 2012 when comparables increased between 5% and 6% per year as consumers traded down given the difficult economic environment. Although Ross has experienced operating leverage over the longer term, margins were relatively stable for several years leading up to 2019. The EBITDA margin reached a high of 16.7% in 2017 but retreated to 15.8% in 2018 and 15.6% in 2019 mostly due to minimum wage increases in various states including California and Florida. In 2019, revenue and EBITDA totaled $16 billion and $2.5 billion, respectively.

Ross generates significant free cash flows given its steady profits and limited need for capital. Net operating working capital is typically negative and capital expenditures as a percentage of revenue average 3% to 3.5%, or 25% of operating cash flow. Free cash flow in 2018 and 2019 was over $1.6 billion. Prior to the pandemic, incremental returns on capital have been very strong. For example, in the seven years ending in 2019, the company spent just over $3.1 billion in capital expenditures and working capital and generated an incremental $1.06 billion in free cash flow to equity over that time frame, good for a return of 34%. For the decade ending in 2019, the incremental return on capital invested was 27%, essentially matching the stocks return over that time. Historically over half of operating cash flow has been used to repurchase stock resulting in a reduction in the share count of over 3% annually. The company has been able to do this while maintaining a net cash balance sheet.

Currently the company has total cash of over $4.4 billion and interest-bearing debt of just under $2.5 billion. Given the unknowns at the time, Ross issued debt in 2020 at attractive rates. For example, it issued $500 million in notes maturing in 2031 at 1.875%. Collectively Ross pays about 3.3% on its debt but is now earning over 5% on its cash which is invested in T-bills. Ross doesn’t need nearly this much liquidity but it is significantly benefiting from higher short-term rates. It has debt maturities in 2024 through 2027 which will easily be paid off as they mature still leaving the company with significant excess cash.

Ross has been able to generate superior returns on capital due to both its scale and business model. Ross and TJ Maxx are by far the two largest players in off-price retail and this scale allows Ross to leverage its costs across a large sales base, especially distribution, merchandising, and advertising costs. The company expands over time, into both new locations as well as backfilling existing geographies which densifies its store network. As densification has increased, Ross has opened new distribution centers to more cost effectively buy inventory and ship it to stores. Its distribution centers, which are mostly owned, are highly automated and designed specifically for the off-price business model. From a purchasing standpoint, given its ability to purchase and receive large quantities of goods with flexible purchase terms and quick payment, and the ability to move goods discreetly, it is a preferred buyer. As Ross’s retail locations are leased, it is an attractive tenant given its ability to generate repeat traffic with the treasure hunt business model. The cost leverage allows Ross to offer good bargains to its customers, which increases traffic, which allows it to sell more and become a more valuable partner for its vendors, which leads to further cost leverage. It is impressive that the company has been able to generate very strong economic returns given that it has relatively low margins and has essentially taken no price in many years. Or at least this is how things worked prior to the pandemic…

As everyone knows, the past three and a half years have been tumultuous to say the least. After many years of relative consistency, the pandemic dramatically disrupted Ross and its impacts are still being felt. Expressed numerically, consensus revenue in FY 2023 will be 22% greater than in 2019, yet EBITDA is roughly flat and free cash flow will be lower due to higher capital expenditures. (The fiscal year runs from February through January). The inflation of the past couple years has uniquely impacted Ross given the fact that the company operates on relatively low margins, has taken little to no price in years, the average ticket is only LDD dollars, and it generally depends on low-cost labor in its stores and DCs.

Obviously when the pandemic first hit, stores across the country were shuttered, with many remaining closed for extended periods, especially in California. As stores were shutting down and uncertainty was rampant, apparel retailers understandably tried to cut costs including pulling back on inventory purchases, delaying receipt, or cancelling orders to the extent possible. Ross’s revenue in Q1 and Q2 2020 declined 51% and 33% from the prior year, respectively. Given the uncertainty of that time and the dramatic decline in sales, the company understandably allowed inventory levels to decline. By the end of FY 2020, average inventory per store was down 16% from 2019 levels. In Q4 2020, the company noted a 100-bps headwind to gross margin due to domestic shipping costs in addition to elevated ocean freight costs as ocean shipping rates began to escalate sharply. It specifically called out a slowdown in receipts due to port congestion on the US west coast. As we know now, the global response to the pandemic snarled supply chains across the world which had significant impacts on shipping costs, both domestic and international. The company also noted wage pressure in Q4 2020, especially in its distribution centers as wages were increased the prior quarter. There were also ongoing pandemic-related expenses. By Q4 2020, the operating margin had declined to 9.5% compared to 13.3% in the prior year due both to escalating costs as well as negative operating leverage given the -6% comparable sales decline.

Retailers battened down the hatches early in the pandemic and supply chains began experiencing major problems by late 2020. However, by early the next year, vaccines became widely available and government stimulus payments piled up in bank accounts across the country. In Q1 2021, Ross had its highest level of quarterly sales ever, growing 145% from the previous year. The comparable relative to 2019 was 13% and this accelerated to 15% in Q2 and 14% in Q3. Given the low level of starting inventory across the industry coupled with slow-moving supply chains and huge consumer demand, Ross and other retailers had to chase inventory which led to merchandising gaps and significant use of packaway. However, pricing was very firm throughout the year given no need for markdowns and Ross actually implemented targeted price increases given frenzied demand.

Merchandising margin increased every quarter in 2021 relative to 2019 due to favorable pricing excluding ocean freight costs. However, given ongoing inflationary headwinds in domestic and ocean freight, the absolute gross margin peaked in Q1 2021 and declined throughout the rest of the year, as did the operating margin. Given that the full-year comparable was 13% yet the operating margin for the year was only 12.3% (i.e. lower than pre-pandemic) shows the significant inflation the company was dealing with.

When Ross reported Q1 2022 earnings, the stock crashed by over 20% as comparable sales declined 7% compared to guidance of a decline from 2% to 4%. Inventory increased 57% compared to the prior year as supply chain issues began to ease and merchandise was received earlier than anticipated and placed in packaway in the face of a sales decline. The company attributed the sales shortfall to lapping the government stimulus payments and huge pent-up demand of the previous year plus lower-income consumers pulling back on spending given rising fuel and food prices. Domestic fuel costs continued to weigh on margins. Despite the pullback in sales, the CEO continued to talk about the potential for pricing:

Ultimately 2022 turned out to be the mirror opposite of 2021 as demand declined, supply chains improved and merchandise was received quicker than anticipated, price hikes gave way to markdowns, and gross margins deteriorated. In Q2, the company cut guidance for the second quarter in a row and noted that higher markdowns were required to move inventory in an increasingly promotional environment only one quarter out from talking about taking price. From the Q2 call:

The company also noted that, while the labor market was stabilizing, ongoing wage costs would be structurally higher moving forward. From the Q2 call:

On a positive, the company noted that there was very good availability of branded merchandise throughout the year as all the inventory ordered in a better demand environment in prior months was being received ahead of schedule into a period of significant discounting.

Throughout 2022 inflation continued to negatively impact with elevated shipping and warehousing costs as well as occupancy deleverage given the decline in sales. However, by the end of the year, the company began to lap significant increases in domestic and ocean freight shipping rates as these costs began to normalize and the business returned to a positive 1% comparable in Q4 2022 and Q1 2023. Management has indicated that the buying environment remains very favorable and, after discounting in the second half of last year, inventory has been rightsized as of Q1 2023 (i.e. down 16% y-o-y).

Obviously, the past couple of years have presented some unprecedented challenges with store closures followed by a huge demand ramp followed by a pullback, not having sufficient inventory, followed by too much, supply chain bottlenecks, shipping and wage inflation, etc. The financial impact of these challenges is summarized in the following table which reflects the dollar impact to cost of goods sold (COGS) on a year-over-year basis due to changes in margins. Positive numbers reflect an increase in COGS, negative numbers reflect a decrease. The table also shows the gross margin, operating margin and SG&A as a percentage of revenue.

• Domestic freight was a significant headwind for six consecutive quarters but has now turned into a tailwind.
• The merchandise margin was positively impacted by significant sales growth in the first half of 2021 but was negatively impacted for five consecutive quarters given steeply rising ocean freight rates and markdowns in the second half of last year. Given current inventory levels and the availability of quality merchandise, Management has indicated that it doesn’t anticipate the need for further discounting.
• Packaway and distribution center costs have been detrimental to gross margins due to wage increases earlier in the period and deleverage due to the opening of a new distribution center (DC) in Texas. As the company laps the opening of the new DC, that margin pressure should ease, especially with positive comparables.
• Due to poor performance in 2022, incentive compensation was lower and buying cost were a benefit to margins. However, given the lower base, this will be a headwind for 2023 so long as the business performs to plan.
• Given the sales declines last year, occupancy expenses delevered and pressured gross margins. As the comparable turned positive in Q4 2022 and last quarter, this eased but the company needs to continue to show comparable growth to turn occupancy into a tailwind.
• Overall, in recent quarters the biggest gross margin headwind was domestic freight and merchandise margin which includes ocean freight and markdowns. Given the lapping of significant increases in shipping cost and recent pullback, the gross margin in Q1 2023 increased by 200 bps quarter-over quarter. Despite headwinds from incentive compensation, once Ross laps the opening of the new DC later this year, gross margins should continue to be more favorable as the year progresses. Occupancy shouldn’t be a major headwind either so long as comparables don’t decline. In other words, freight, merchandise margin, packaway/DC costs, and occupany are all trending in the right direction. The primary remaining headwind to margin recovery is buying costs.
• SG&A as a percentage of revenue was unfavorable in the most recent quarter due to the reinstatement of incentive compensation as well as higher store wages. The company has said that the labor situation has improved in the past couple of years and is stable, but given ongoing wage inflation in the economy, this will likely remain a challenge moving forward. Over the past decade, SG&A per square foot has increased at a rate of 2.6% per year, so higher comparables would go a long way towards helping alleviate wage pressures.

For both COGS and SG&A, it is important that Ross returns to its historical level of comparable sales growth of 3%. Again, the past three years have been tumultuous with sales falling off a cliff when stores closed, to quickly ramping to record levels in 2021, followed by declines the following year. Longer term I don’t see why Ross’s historical model of 4% to 5% growth in stores paired with a 3% comparable is broken once we return to a more normal macroeconomic environment. The company has yet to see any impact from consumers trading down despite higher inflation negatively impacting consumers; however, I think this will ultimately happen if the economy slows which would likely benefit Ross.

The company has said that one point of comp is good for 15 bps of operating margin expansion. I think now with shipping costs having come down, the labor situation stabilizing, the company lapping the opening of its latest DC, and positive comparables the past two quarters, things are moving in the right direction. However, given the valuation today, I think the stock is attractively valued even if things don’t materially improve from here.

Based on a stock price of $114, the market cap is $38.8 billion. With debt of $2.46 billion and cash of $4.42 billion, the EV is $36.9 billion. Net cash represents 5% of the market capitalization. The company could pay off all its debt, repurchase stock, pay the dividend and still have over $2 billion in cash by the end of this year. Just by investing its cash in T-bills, the company will generate interest income approaching $250 million. In the two years prior to the pandemic, Ross generated over $1.6 billion in free cash flow. The company will likely generate slightly less than that this year and more than that the following year.

I model net store growth at 4.5% this year slowing to 3.7% by 2028 (opening the same number of stores on a growing base) and sales per store (not comparable sales, rather sales per average store) growing by 1% per year, compared to 2% historically. Overall revenue growth is approximately 5.5%. With a little bit of help from sales leverage, I model the operating margin reaching 12.6% by FY 2026, which is still lower than the five years prior to the pandemic, which averaged 13.8%. Management has suggested it will pay off maturing debts with relatively small amounts of debts maturing in 2024 through 2027. Assuming this debt is repaid, the dividend grows by 10% annually, and all excess cash above that needed to maintain $2 billion in net cash is used for share repurchases, Ross will retire around 3% of shares outstanding every year. MSD sales growth, a small amount of operating leverage as inflation fades, and a 3% reduction in shares results in DD compounding in free cash flow per share, which will reach over $8 in 2027. Assuming the stock trades at 20x free cash flow, which is lower than it has traded historically, the return from here is low double digits, including the dividend.

Ross has created significant value for shareholders over the long term, yet the stock is trading at the same price today as it was in November 2019. The pandemic and society’s response to it had profound implications for Ross, mostly negative. However, now with the pandemic fading into the background and inflation coming down to more moderate levels, the economic outlook is getting closer to “normal” than it has been in several years. Given receding shipping and ocean freight costs as well as a normalizing labor environment, margin improvements are likely moving forward. I believe there is a good possibility that Ross will revert to its historical, value-creating trajectory in the coming quarters. With over a decade of footprint growth ahead and a return to a more normalized growth and cost environment, I think Ross is on the verge of growing free cash flow per share to new highs, and likely at a DD rate over the next few years all while maintaining a net cash balance sheet. Assuming share repurchases continue, free cash flow share will nearly double over the next five years, leading to double digit total returns in the stock.

Catalyst

• Continued declines in cost inflation
• Pickup in comparable sales
• Share repurchases