Description

Ross Stores (“Dress for Less”) operates over 600 off-price retail apparel and home accessory stores across the United States. The company’s focus is on selling brand name products and designer merchandise at a discount (targeting prices 20% to 60% below those at department stores). Ross’ largest market is California, where the company has 32% of its stores. Fourteen percent of stores are in Texas and 12% are in Florida. The company targets middle to upper middle class individuals, primarily women.

Ross purchases its merchandise directly from manufacturers and from retailers looking to unload excess inventory and capitalizes on mismatches of demand between manufacturers and retailers and between retailers and higher end customers. The majority of the merchandise purchased is during or at the end of a season as “closeouts” or “packaways.” The type of merchandise purchased usually is a fashion basic (i.e. won’t be “out of style” when sold by Ross).

Ross is currently trading at $21.75, near its 52 week low (range of $21.60 – $32.86) as a result of significant issues with merchandise and inventory management. After years of having an efficient infrastructure, the Company decided in 2002 to upgrade its system with Accenture. The process has been far more painful and costly than the company ever imagined. Ross merchants/vendors haven‘t been able to fully understand information on customer unit demand, pricing, and regional trends. Without inventory visibility, the process of purchasing merchandise from manufacturers and assessing demand at Ross’ own stores has been severely impacted. As a result, same store sales growth has been flat for the first half of 2004 (and is currently falling, Ross anticipates posting a horrific -10% August figure…) and operating margins have declined by nearly 200 bps from historical levels.

While issues with inventory may persist for the rest of 2004 (management believes the problem will be solved by the end of August, with only lingering effects for the rest of 2004…), Ross’ successful business model is still intact for 2005 and beyond. At current valuation levels, in light of the company’s strong balance sheet, growth prospects, and competitive position, Ross is a compelling opportunity for an investor with a long-term horizon.



Valuation:

Based on my base case estimates, Ross currently trades at 16.5x 2004 earnings and 12.6x 2005 earnings.

($ in millions) 2002A 2003A 2004E 2005E
Revenue 3,531 3,921 4,250 4,750
Rent Adj. Gross Profit 1,135 1,223 1,296 1,496
EBIT 331 374 319 408
Net Income 201 228 195 249
Diluted EPS 1.26 1.47 1.32 1.72
Free Cash / Share 1.14 0.78 -- --
P/E Ratio* 16.8x 14.8x 16.5x 12.6x
ROE 31.3% 30.2% 24.9% 28.6%
Diluted Shares (mm) 159.5 155.2 148.5 144.9

*2002 P/E is based on 2002 year end stock price. Subsequent ratios are based on current stock price of $21.75.
Note: Each annual fiscal year ends in January of the next year in table above and elsewhere in writeup.

With the first two quarters of 2004 completed, my 2004 estimates are roughly in line with the Street’s views (consensus estimate of $1.30). However, I believe that 2005 estimates for Ross are too conservative (consensus estimate of $1.63) and either ignore 1) the company’s historical margins and potential for operating leverage when combined with revenue growth or 2) the potential impact of the company’s share repurchase program.

I have assumed 12% top-line growth in 2005. Historically, Ross has achieved double digit top line growth by increasing store square footage 6-8% and compounding this growth with 4-5% same store sales increases. In recent years, management has increased the number of store openings annually as it became apparent that the operational leverage that was achievable by doing so was not in direct conflict with margins, which have more or less remained steady. In 2005, the company plans to increase square footage by 12% through roughly 70 net new stores. By assuming 12% revenue growth, same stores sales growth of roughly 0-1% is implied (slight haircut for new store productivity…), which is conservative in light of the 4.8% average over the past decade. Additionally, to achieve net income of $249 million, assumed are an operating margin of 8.6% and a net margin of 5.2%, both below 1998-2003 averages of 9.5% and 5.8%, respectively. While both margin figures for 2005 are above 2004E levels, it is important to note that Ross’ margins are driven by operating leverage from surpassing a threshold revenue growth level, which they have had trouble reaching this year due to the inventory management issues. Lower margins in 2004 aren’t due to a fundamental change in the business that is likely to persist when issues are resolved.

Consider this net income in conjunction with Ross’ share repurchase program. According to the current share repurchase plan, the company will repurchase $350 million of shares by the end of 2005 (have already repurchased $124 million of shares under this plan). At current valuation levels, Ross could repurchase up to 9 million more shares by the end of 2005, reducing the weighted average diluted shares to 144.9 million (fairly conservatively assuming a repurchase price of $24). An important note about the share repurchase is that Ross has consistently executed its planned share repurchases. Ross, since 1994, has repurchased 25% of its shares outstanding as a use for its strong free cash flow.

In aggregate, in what I consider to be a fairly conservative scenario, Ross will earn $1.72 per share in fiscal year 2005, including a free cash flow yield close to 7%. While 12.6x forward earnings isn’t what one would call dirt cheap by any stretch of the imagination, I believe that this is in fact somewhat of a base case; a more aggressive scenario is very plausible. If Ross achieves same store sales of 3% (below its historic average of 4.8%) and a net margin of 5.7% (also slightly below its historic average…), Ross would earn $1.91 per share in fiscal year 2005. It’s difficult to put a likelihood on this scenario, in which Ross trades at 11.4x forward earnings, but the company has a history of performing beyond expectations and the drivers of this occurring are fairly plausible.

Is there a downside scenario? Of course. However, even this type of scenario isn’t terrible…If same store sales decline by 3% and net profit margin remains at dismal 2004 estimated levels of 4.6%, Ross will still earn about $1.47 per share in 2005, implying a current valuation of 14.8 forward earnings. Not a great price for a retailer but not a terrible downside scenario.

What enables Ross to survive difficult situations unscathed is the company’s strong balance sheet and return on capital. With only $50 million of debt, the company doesn’t rely on financial leverage to survive. With minimal leverage, Ross has achieved a return on equity greater than 20% for every year since 1996. Even in 2004, as the company struggles to deal with internal problems and an increasingly difficult environment for retailers, Ross will achieve a return on equity of approximately 25%.



Growth & Customer Base:

From 1994-2004E, Ross has increased its revenues by approximately 13.0% on an annualized basis. Due to strong cash flow generation, the company also has increased its earnings per share by 18.2% annually over the same time period. While Ross isn’t necessarily a transcending growth story, I believe that this level of top-line and EPS growth is sustainable in the foreseeable future for several reasons.

Ross Stores target shoppers are generally middle to upper middle class individuals. Customers aren’t interested in service and they aren’t interested in a fancy story. They are driven by Polo shirts for $15 (and are often willing to fight for them!). It sounds crazy, but if you visit a store and talk to employees, they’ll attest to the fact that the worse the stores looks, the more merchandise they in all likelihood are selling. If shirts are strewn all over the floor, that means customers were excited by the “treasure hunt.”

I’m painting this picture not to be the Kerouac of investing (although that does sound initially appealing…) but rather to get across an important point about the customer base. These stores don’t sell typical low end products to low-income families. Ross sells its products to middle to upper middle class bargain hunters. And as these individuals have found what they were looking for repeatedly over the years, a very sticky customer base has emerged. Why go to JC Penney or Bloomingdale’s for a pair of $60 pants if you can get that exact same item hidden in an aisle of Ross for $35? Ross exemplifies the fundamental nature of rebates. Customers that are willing to put in the extra effort, in this case suffering the pains of searching through aisle after aisle of merchandise, can in all likelihood find high quality brand items for a significant discount.

Not only does Ross Stores have a loyal customer base, but they also have a store base from which they can grow in all market environments. Ross’ same stores sales have, on average, increased by 4.8% annually from 1994-2003. According to the Bureau of Economic Analysis, the clothing and accessories subsector of GDP has grown by 1.8% annually since 1994. It has experienced only one year of decline, a 0.1% decrease in 2001. In 2001, Ross posted a solid same store sales figure of +3.0%. The key, obviously, is that, not only has Ross been able to grow, but because of their focus on discounts, they have been able to do so even in problematic market environments when traditional retailers face significant issues.

The reason for their success in difficult environments is two-fold. Firstly, Ross is able to attract more customers during economic downturns. Struggling consumers looking to cut costs are drawn to Ross and the possibility of maintaining their lifestyle at potentially lower costs (more customers in line for rebates…). It is important to note that these very customers attracted in an economic downturn can become loyal customers, who once lured by the discount model have a tough time returning to costly department stores. Secondly, in an economic downturn, the mismatches in demand between retailers and manufacturers and between retailers and high end customers are exacerbated. Levels of inventory that otherwise would never have been available can be purchased by Ross at extremely affordable levels. Ross’ financial strength provides the company incremental flexibility in these situations. In this light, Ross is a great defensive investment in the retail sector. The company certainly will never be as explosive as fashion driven retailers but the ability to thrive and attract customers in all market environments is extremely attractive.

Additionally, it is important to discuss dd's DISCOUNTS stores as an additional avenue of growth, dd’s DISCOUNTS is a new type of store targeting lower income individuals that Ross is currently unveiling. The company has opened three of these 25,000 square foot stores in northern California. No word yet on their success, but Ross anticipates that the overall opportunity for these stores will be up to 500 locations. These stores will be somewhat similar to TJX’s AJ Wright concept. While the young TJX chain has struggled to achieve profitability, it finally has achieved this goal and, in the past three years, posted impressive same store sales growth of 8%, 11%, and 18%.



Competition:

Extensive competition exists in the specialty discount retail sector. Several regional players exist and fight for market share. The main threat, however, is TJX.

TJX

TJX owns and operates TJ Maxx stores, Marshalls, Winners, HomeGoods, AJ Wright, and Bob’s Stores. The company, with an extremely similar business model as Ross, currently has over 2000 locations. I believe that Ross Stores is a more attractive investment because of its superior growth prospects, potential for geographic diversity, and relative valuation

With regards to growth, the most basic advantage Ross currently enjoys is size. Ross is currently a third the size of TJX in terms of stores. While it is difficult to assess the market opportunity, it is reasonable to believe that Ross will have more growth potential in upcoming years. Moreover, I don’t believe that TJX’s size is of the nature that it will be able to achieve significant economies of scale / superior operating leverage. In the 26 states in which Ross does have a presence, it has achieved strong relationships with manufacturers / retailers and the likelihood of TJX being able to get significantly better deals for inventory doesn’t seem particularly likely. Why create a monopoly? On the other side of the equation, it doesn’t seem as though TJX has been able to achieve superior margins to Ross, which would indicate that their scale has not enabled them to achieve superior operating leverage. While this of course might simply represent them selling products at better prices, having been to both stores this doesn’t seem at all obvious.

It is also important to note that a reasonable component of TJX’s growth has been through acquisition, most recently Bob’s stores. Even though TJX has been stronger this year, this has been driven by growth from acquisitions in recent years. The company’s core MarMaxx franchise (TJX and Marshalls) experienced a -1% same store sales decline this past year and only a +2% and +3% figure the prior two years, respectively.

TJX is far more geographically diversified. While this diversification has helped TJX maintain growth, it also points to the potential saturation of the company’s core franchises in its primary markets. Obviously this geographic diversity also provides strength in the face of a regional economic downturn, but in terms of growth, it provides a huge opportunity for Ross. Ross currently has a presence in only 26 states; the ability to grow from its core locations in California, Florida, and Texas is significant.

Both companies are currently at similar valuations. TJX is trading at 15.2x 2004 estimates and 13.2x 2005 estimates. However, the upside in Ross’ earnings due to the potential correction of inventory issues and higher terminal levels of growth make Ross a more compelling situation. That being said, I don’t believe that one would be going terribly wrong with an investment in TJX. It’s a sound company with decent management and future prospects.

Department Stores

If department stores make the decision to consistently increase their discounts it certainly would adversely affect Ross Stores. However, in light of their higher overhead costs and the potential disgruntlement from high end customers for reduction in service (which would be necessary to compete with the likes of Ross and TJX…), it is questionable how sustainable this business model would be. It certainly would be a problem in the short run though.

Regional Discount Players

I initially glossed over the regional players to discuss TJX. I don’t believe that they pose a significant threat to Ross Stores, or TJX for that matter. The broad distribution capabilities Ross and TJX possess makes them far more attractive as places to unload excess inventory. Having to distribute items to several regional players is simply a much bigger chore than selling in bulk to Ross or TJX. Additionally, because of both companies’ scale, it is unlikely that these smaller players can bid as aggressively if need be.

The biggest threat to Ross from regional players probably involves their being acquired by TJX. TJX has been far more acquisitive in the United States, Canada, and the U.K. While this does pose a potential problem, acquisitions thus far haven’t been problematic in creating head to head competition between TJX and Ross (as opposed to a regional player against Ross). In this regard, it is important to note that Ross management has indicated in the past that their stores actually do well in locations in which they are up head to head against TJX (although this undoubtedly occurs more often in densely populated environs…)

Foreign Competition

I don’t believe that foreign competition is an issue. The important thing to remember is that the customer base is predominantly middle to upper middle class individuals. These aren’t the same individuals that are willing to buy knock-offs on the street, even though quality of product is probably more or less the same…

“Wal-Mart”izataion

Is Wal-Mart a concern? In my estimation this is a “no.” For higher-end retailers / manufacturers to sell product to Wal-Mart is suicide. This would only happen on a large scale after capacity at Ross, TJX, and other smaller discount retailers was amply filled. A large part of the reason Walmart sold McLane to Berkshire was the fact that many customers simply weren’t willing to adopt a wholesale relationship with Walmart. While this would be the reverse scenario, I believe that the same logic applies. Walmart, however, could threaten the dd's DISCOUNTS stores. Without having ever been to one of these stores (need to make the West Coast trip come December!), it is difficult for me to assess the size of the threat.



Management:

While I have never met with management, most of the team has been together for a number of years, an especially important fact for an off-price specialty retailer. CEO Michael Balmuth, who only owns about 0.5% of the shares outstanding, seems to have done a good job since joining the firm in 1989. Additionally, of some note is the fact that, in 2004, Balmuth has only sold shares in the $28-30 range.



Risks:

This write-up essentially assumes that the inventory issue will be addressed by management with the help of Accenture. This certainly isn’t a given. The problem has taken a longer period to address than originally thought and there are no guarantees that it won’t affect the fundamental relationship between Ross and its customers on a more permanent basis. Ross’ management has been together and successful for a long period of time and faith in their ability is somewhat of a prerequisite.

Additionally, it is entirely possible that inventory issues aren’t entirely responsible for Ross’ problems. The company could be experiencing several problems, internal or external, that management is lumping together as being a part of this issue. This is a legitimate concern. Again, Ross’ long track record of success perhaps is the best defense against the notion that the company would face significant problems on several fronts beyond those of which we are currently aware.

An extensive economic slump would impact Ross less so than it would other retailers but this certainly would have a significant impact on the company. The positive spin with this is that the company has an extremely clean balance sheet (stronger than TJX’s…) and probably could outlast many competitors.

Rising energy prices is a concern of which, to be perfectly honest, I have an extremely difficult time quantifying the effects. Does $50 oil mean middle class families will shop less? Probably. Does it mean that they will continue not to do so on a pro-longed basis? Maybe…



Conclusion:

-Ross is a financially strong, relatively high growth company that offers an attractive, defensive opportunity in the retail sector
-Mended distribution/inventory issues and the company’s extensive share repurchase plan could help fuel significant earnings per share growth in 2005 and beyond

Catalyst

-Ross and Accenture address the distribution / inventory management problems
-Use of cash to repurchase a large percent of the shares outstanding