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Ross Stores (ROST) Analysis: Need a bit more time and slightly lower price (Part II)

October 20, 2010 | About:
This is the second part of my analysis of ROST as a potential long investment. You can find the accompanying spreadsheet on my blog Margin of Safety Investing

2.3 Financial Health

Liquidity

ROST’s working capital management is good, with a current ratio of 1.5x as of last reporting quarter. This ratio is in line with the company’s past performance, ranging between 1.4x and 1.6x which is somewhat conservative for a retailer and does not worry me. Out of ROST’s $1.9B current assets, about $700M is cash and $900 is inventory which turns quite fast (cf. below!). ROST carried no short term debt as of 07/2010.

Ross has a very short cash conversion cycle . The company usually gets paid within 2 days (days sales outstanding), carries inventory for 60 days (days inventory) and itself pays its obligation within 40 days (days payable).

Debt

ROST only carries $150M in debt which is very low, representing less than a couple of month’s worth of free cash flow. In addition, ROST does not appear to have any pension liability.

$ millions, except per share data
2006 2007 2008 2009 2010 TTM
Total Debt / Equity 0.1 0.2 0.2 0.2 0.1 0.1
ST % of Total Debt 100% 0% 0% 0% 0% 0%
Total Debt / FCF 0.3 0.5 1.3 0.4 0.2 0.2
Op. Income / Interest 42.1 61.9 79.9 210.5


ROST’s strong credit position is also reflected in its Altman z-score of 6.8 and its Piotroski score is 8, missing a ‘perfect score’ of 9 due to decrease from 2.80x to 2.66x in asset turnover,

In conclusion, ROST is in a strong liquidity and cash position. Given this strong situation, I will not increase my margin of safety requirement of 40%. As the company is still growing at a good pace and due to the potential for volatility it entails, counterbalanced by a stable/conservative B/S approach, I will use a cost of capital of 11% for our DCF valuation below.

2.4 Historic use of cash

Dividends, Buybacks and returns on retained earnings

ROST pays a small dividend, yielding investors a 1.1% yield on a payout ratio of around 15-16%. ROST however does do a large amount of stock repurchases every year, retiring about 4% of its shares per annum over the last 5 years; given that the company’s stock price has been generally trending up the return of the buyback may have been satisfactory. However I would prefer the company were to pay a bit more in dividends, around 2%, and a bit less in buybacks which can be volatile and whose returns to investors are less certain.

ROST current share plan allows for ~$750M in share repurchases over 2010 and 2011, and management has announced its intention to use it fully, buying back $375M worth of share every years.

ROST use of retained earnings has been satisfactory as the company has been able to gain strong returns on its retained earnings. On a 5-year basis, ROST retained $9.26 per share and increased its EPS by $2.41 over the same period, a 26.0% return. On a 10-year basis the return has also been strong, at 19.3%

$ millions, except per share data Growth Rates
2006 2007 2008 2009 2010 TTM 3-yr 5-yr 10-yr
Dividends 31 34 41 50 55 66 16% 17% 20%
Dividends per Share 0.21 0.24 0.30 0.38 0.44 0.55 21% 21% 24%
Diluted EPS 1.36 1.70 1.90 2.33 3.54 4.29 36% 25% 14%
Payout Ratio 16% 14% 16% 16% 12% 13% 14% 14% 12%
Retained earnings per Share 1.15 1.46 1.60 1.95 3.10 3.74
Diluted Shares (M) 147 142 137 131 125 121 -4.5% -4.0% -3.1%
Note: Growth rates calculated using log-normal regression and exclude LTM


[/b]

3 Valuation

[b]3.1

Expected intrinsic returns In addition to a potential valuation benefit driven by the margin of safety (cf. below) returns for an investor will be driven by: dividends, growth and share buybacks / improvement in cash position.

Ross currently pays a 1.1% dividend yield using 15% of its TTM earnings (or $0.55 per diluted share as of 07/2010). In addition, ROST will use about 30% of its earnings at 29% ROE to fund its estimated growth rate of 8%, leaving $2.56 for share buybacks/increase cash. At the current price of $53.7, ROST could buy back up to 4.8% of its shares back.

Adding these returns together leads us to a total intrinsic return of 14%. While this is quite high, share buybacks are in line with the company’s practice over the last few years and growth is set to be at the lower end of the company’s performance in previous years.

3.2 DCF

To evaluate the value of the company I am relying on a discounting cash flow calculation with the following assumptions:

- 2010 Free Cash Flow of $600M (cf. Profitability and Growth section above)

- Growth for next 5 years: 8% (cf. above), declining to 5.5% years 6-10 and then 3.0% years 11-20

- Cost of capital: 11%

- Terminal value in year 20 with no growth

This leads to a DCF value of $9.0Bn for the company, before accounting for net debt. Using a 40% margin of safety on this valuation leads to a per share entry price of $44, to which I am subtracting ROTS’s net debt position of ($4850M net cash position) leading to a price threshold for investment of slightly over $48.

I believe this evaluation of ROST value to be conservative but potentially still risky, using a starting FCF in line the performance of the last twelve months of last year’s FCF of $614M as a starting position which is itself fairly down compared to the FY performance of $730M.

ROST has recently traded in the $49 to $56 range which only at the low end could provide for an adequate entry point. However, we are not there yet and I would like to have a bit more “certainty” around the company’s FCF performance, which will become more clear over the coming quarters.

4 Conclusion

Despite the strong performance over the last 10 and 5 years, I am still a bit nervous about volatility of the FCF in recent years, giving us an “un-sure” (to the extend that anything could be sure in valuation!) starting point for our DCF valuation. In addition, our valuation gives us an entry point of ~$48 which is slightly below where the stock currently trading. I believe ROST could present a good opportunity if the price were to drop below that threshold and a few more quarters have passed, confirming ROST’s Free Cash Flow levels.

Disclosure: I do own ROST share which I bought a couple months back at~$51 and will probably be selling them in the coming weeks unless some positive news surface on the cash flow front in the current quarter.


Rating: 3.7/5 (3 votes)

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