Description

Investment Summary

We are long Ross Stores (NasdaqGS: ROST, “Ross” or “the Company”), which operates off-price retail apparel and home fashion stores under the Ross Dress for Less and dd’s DISCOUNTS brands in the U.S. ROST primarily offers apparel, accessories, footwear, and home fashions. The Company’s Ross Dress for Less stores sell its products at department and specialty stores primarily to middle income households (with savings typically in the range of 20-60% off regular retail prices), whereas dd’s DISCOUNTS stores sell its products at department and discount stores to customers from households with moderate income (with savings typically in the range of 20-70% off regular retail prices).

As of the end of 2017, ROST operated 1,622 off-price apparel and home fashion stores (1,409 Ross stores and 213 dd’s stores) in 38 states. The top three states are California (379 stores), Texas (230 stores), and Florida (195 stores), so these states account for 50% of the Company’s total store count. ROST was founded in 1982 and is headquartered in Dublin, California.

Despite already being a fairly large retailer with a $32 billion market cap and $14 billion of sales, ROST has demonstrated strong growth in a challenging retail environment and continues to have attractive growth prospects. At the end of 2012, the Company had 1,200 stores, and in the past five years grew its store count to 1,622, a CAGR of 6%. Over this time period, ROST consistently opened 90-100 new stores each year, while closing just 5-10 stores each year, resulting in strong net unit growth. ROST’s total sales also increased from the consistently strong performance of the existing store base, which comped 6% in 2012, 3% in 2013-2014 and 4% in 2014-2017, while sales/sq ft increased from $355 in 2012 to $409 in 2017. This performance is remarkable in a challenging retail environment as more physical sales shift online, especially given ROST does not have an online presence whatsoever. It’s worth noting that in the past 20 years, the Company only had one year of negative SSS, which occurred in 2004 when SSS declined 1%. Notably, in 2008 and 2009, SSS actually increased 2% and 6%, respectively. We think recent SSS strength has in part been due to the poor performance of department stores, which have allowed ROST to increase traffic and gain share, and we expect this trend to continue.

LTM levered free cash flow was $1,260mm, implying ROST is currently trading at a 25x LTM FCF multiple, which may sound expensive at first glance. However, we think ROST can grow sales 9% per year (3% from SSS and 6% from new stores) for the next several years, or ~10% EBITDA growth per year (assuming very slight margin expansion from increased scale). Given the lack of leverage, we think EPS and free cash flow will also grow ~10% per year for the next several years, implying that today investors can buy in at a 4% levered FCF yield while receiving 10% growth for a 14% annual return (assuming no change in multiple). Importantly, the 4% current yield is a real return in the sense that the majority of FCF goes to share buybacks (primary use) and dividends (secondary use, 1% current dividend yield), with the remainder accumulating as cash on the balance sheet.

Management believes ROST has long-term store potential of 2,500 locations across the U.S., versus 1,622 at the end of 2017, implying 54% growth potential. Assuming ROST increases its store count by 90 net stores per year, the Company would hit its 2,500 location target in 2027, or approximately 9 years from today, implying many more years of growth to come.

ROST is currently trading at 12x 2019E EBITDA and 19x 2019E P/E (closest comp TJX is trading at 11x 2019E EBITDA and 18x 2019E P/E, so fairly similar). Management has guided towards ~$4.00 of EPS in 2018E. Assuming 10% of annual EPS growth would result in EPS growing from $4.00 in 2018E to $5.85 in 2022E, which assuming a 22x forward P/E multiple (up from 19x P/E today) would result in a share price target three years from now (i.e. July 2021) of $128.84, or 51% upside from today’s share price and a 15% IRR. Including the 4% annual free cash flow yield in the form of buybacks and dividends increases the IRR to 18% (without any multiple expansion, the IRR would be 13%). Given ROST is a best in class operator with a strong track record and secular growth story with many years of growth to come (by our estimates, ROST will not hit its 2,500 location target until 2027, implying three years out from now (i.e. in 2021) there will still be several years left of growth, allowing for the Company to still trade at an attractive multiple), we believe the Company should trade at a 22x forward P/E multiple.

One catalyst could occur if ROST were to lever up and do a large buyback/dividend, which would accelerate returns to shareholders. The Company currently has a net cash position of ~$900 million and could raise ~$7 billion of debt, or 22% of the current market cap, and return those proceeds to shareholders, while subsequently having low leverage of 2.5x LTM EBITDA.

While recognizing ROST’s share price, unlike the products in its stores, may not currently be super bargain priced, we believe the Company offers a good risk reward in the form of an operator that has consistently performed well and generated shareholder value in a variety of economic environments and should continue to have good and tangible growth prospects for several years to come. Our targeted IRR of 18% could be increased by levering the long position, which we think would be appropriate and not overly risky given ROST currently has a net cash position.       

Risks

As mentioned above ROST is not cheap, currently trading at 25x LTM FCF multiple (relative to a 5-year average of 25x), 13x LTM EBITDA (relative to a 5-year average of 11x) and 22x LTM P/E (relative to a 5-year average of 21x). However, ROST is trading just slightly above its historical average multiples, and therefore does not screen overly expensive either.

Another key risk is ROST does not grow as quickly as planned due to there being a more limited number of attractive greenfield opportunities than management has indicated. Struggling retailers have recently been reducing the number of new stores they open and closing down more stores, so that net store growth for these retailers is very slightly positive (and sometimes even negative). This has not been the case with ROST, which has seen its number of new stores opened each year increase on an absolute basis. For example, in the early 2000s, ROST was opening just 30-60 new stores per year, and by 2011 was opening 80 new stores per year. From 2012-2017, ROST opened as few as 82 new stores (2012) and as many as 96 new stores (2017), demonstrating the number of new stores opened each year is increasing. Should ROST no longer have attractive greenfield opportunities, we think the number of new stores opened each year would be declining, which has not been the case.

A third risk is that SSS begins to decline, possibly due to an economic correction/recession, which many investors believe is likely to occur in the next 1-3 years. A mitigant is that ROST actually comped positively during the most recent recession and in the past 20 years has only had one negative SSS year. While this is a historically looking analysis and doesn’t mean ROST won’t face macro/competitive pressures in the future that could cause the existing store base to underperform, we believe management has a long-dated track record of running the stores very efficiently and performing with positive SSS in a number of economic environments. We believe the reason for ROST’s success is that being an off-price retailer appeals to a wide demographic (both wealthy and middle/lower income) in all economic environments because everyone loves to save, not just during a downturn. ROST’s customer base is 70-75% female, and many of them are older shoppers that are baby boomers and have retired. Channel checks confirm the “treasure hunt” appeal ROST has for these shoppers is real and compelling, and is not easily replicated through online shopping where many shoppers fear that the savings they realize are due to the items being fake/damaged, whereas at ROST they can shop worry-free knowing they are buying real brands. For the baby boomers, shopping is a way for them to get out of the house, and our conversations indicate many women will spend hours at ROST. Further, they describe finding a brand name and highly marked-down apparel item at a Ross store to be “thrilling.” As a result, we think ROST’s customer value proposition is strong, resistant to the threat of online, and will remain in place for many years to come.

A final risk is that margins are currently on the high end and could revert to historical averages. For example, from 1996-2006, the Company’s gross margins varied from a low of 22% in 2005 to a high of 31% in 1998. Gross margin was 22.5% in 2006, 22.7% in 2007, 23.6% in 2008, 25.8% in 2009, and 27.2% in 2010. Therefore, ROST actually grew its gross margin during the financial crisis. Gross margin has steadily increased since then, and in 2017 was 32.7% (gross margin was consistently in the 32-33% range from 2011-2017). While the Company’s gross margin is currently on the high end, the fact that the current gross margin has been achieved in the past in the late 1990s (as opposed to never before) gives us comfort that ROST’s margins are not overly elevated. In fact, the Company believes its gross margins are sustainable, due in part to management’s excellence in merchandising, which helped drive gross margins higher over the past decade. As ROST continues to grow and become a larger buyer, we think its negotiating power with brands and vendors will continue to strengthen, resulting in the potential for even further margin expansion, especially as the Company continues to invest in inventory management and improving processes and technology, such as managing expenses in its distribution centers, stores and back-office functions. As a testament to the Company’s operational improvements, we note that over the past decade ROST’s working capital metrics and cash conversion cycle have improved meaningfully, with inventory days declining from 86 in 2006 to 62 in 2017 and the cash conversion cycle declining from 38 days in 2006 to 24 days in 2017, a significant improvement and once which has allowed the Company to generate greater FCF.

Catalyst

Earning announcements, continued strong new store growth and SSS performance