Strong Earnings Momentum Continues to Favor Ross Stores

Strong, upward trending, stable earnings make Ross Stores one of the best retail stocks on the market

Apr 17, 2019

Company overview

What a success story this company has been. Ross Stores Inc. (ROST, Financial) has grown into the largest discount clothing retail store in the United States. Operating through two chains, the company has over 1,300 Ross locations spread across 36 states and 193 DD’s Discounts store locations spread across 15 states.

The Ross Stores chain sells high-quality, designer and brand name clothing and home accessories at deeply discounted prices relative to department and specialty stores. The company estimates it sells most products at a 20% to 60% discount with its target client-base being young and middle-aged, middle income households.

The DD's Discounts chain sells modest quality brand and generic clothing and home accessory products at even lower prices than Ross Stores. Specifically, the company estimates the average client saves about 30% to 80% compared to standard retail prices. Most stores are located in shopping centers in modest income neighborhoods and target even more value-conscious customers.

The company's management believes it retains a strong competitive advantage that is derived by offering a wide range of well branded and in-fashion products discounted at enormous prices relative to the competition. Management also believes its stores are very friendly, well organized and create a pleasant, easy-to-shop environment that encourages customers to come back.

Ross Stores’ sales can be broken down into the following categories: 28% Ladies, 25% Home Accents and Bed and Bath, 13% for Accessories, Lingerie, Jewelry and Fragrances, 13% for Men's clothing and 8% Children’s clothing and toys.

Management estimates about 75% of total store foot traffic is female and that customers visit store locations on average about 36 times a year.

Purchase considerations

Operationally, there are many reasons why we like this company:

Ross has proven itself time and time again to be a relatively solid and stable business and is largely insensitive to business cycle shocks.
Year over year. this company has been able to maintain positive same-store sales (approximately 4% per year).
Local demand for Ross Stores stores continues to grow, with the company expanding, on average, by about 80 stores per year (and closing less than 10 stores per year).
This is the type of business that actually benefits from an economic downturn or recession (as customers become more cost conscientious, the demand for Ross Stores’ products increases). And the opposite isn’t always damaging, meaning sales do not diminish proportionately with an economic expansion as they grow with an economic recession. This is a great business to own from a diversification and risk mitigation perspective.
This is a retail company that is tremendously profitable, with Ross Stores' margins consistently over 28%, return on equity over 40% and return on investment over 50%. This type of profitability is very difficult to find in today’s retail space, with most companies bleeding money as they try to compete with Amazon (AMZN, Financial).
Cash returns to investors remain north of 8% and we expect these returns to hold steady or decline only modestly over the next several years.
The company has been successful at controlling operational costs due primarily to new merchandising agreements with suppliers and improved inventory management systems. We believe more still needs to be done in this area to ensure shelves are properly stocked and the mix of goods continues to meet consumers’ needs.
While management continues to focus on domestic expansion, we do believe international expansion opportunities remain in its future and, if executed effectively, could provide solid sales and profitability growth for years to come.

Cautionary notes

What we dislike most about this business is that the quality and mix of its inventory base is largely dependent on the decisions and performance of the specialty retail and department stores. More specifically, when a shortage of high-quality, in-fashion clothing products emerges within the “normal” retail environment, Ross Stores can face severe difficulties accessing the products customers want. Currently, there appears to be a surplus of high-quality, in-fashion products and Ross Stores has benefited by being able to source these products at discounted prices. It is difficult to say how long this will continue, if at all.
It’s also possible that retailers, or manufacturers, will refuse to source to Ross Stores if it is felt the company is cannibalizing their own sales and hurting their margins.
We also remain a little concerned about Ross Stores’ inventory management system and believe that, while improvements have been made, its main competitors have still succeeded in creating more accommodating and more enjoyable shopping experiences for customers. This could prove to be a challenging obstacle for management to overcome.

Valuation methodology

For the purpose of assessing this company, we utilize a framework that we call the earnings calibration model. The methodology is founded on a strong momentum-based stock selection criteria. First, we apply some basic screens to assess the company's earnings strength, balance sheet health, valuation levels and value trap risk. Finally, we estimate the company's rate of calibration, set a valuation range and determine the return potential inherent in the stock.

Principal screens

Screen #1: Is the company a competitively strong company?

The first step in the model is to perform a quick analysis of the company's ability to generate positive economic profits or positive residual income. If preliminary research generally satisfies this condition, then it is worth moving on to the second screen. To assess whether the company has produced a history of positive residual income, we calculate (1) the spread between the company's return on invested capital and weighted average cost of capital and (2) the spread between the return on equity and required rate of return on equity over as long a period as possible. (Note the required return on equity is calculated using the capital asset pricing model.)

Based on the historical numbers, Ross Stores appears to be a competitively strong company. As can be seen in the figure above, it earned substantial residual income with an average ROI-WACC spread of 58.7% and an average ROE-Re spread of 39.6% over the last 10 years. The more recent data confirms the historical data with Ross Stores' 2019 economic profit spread averaging 56.2% over the last three years and its current profit spread at 65%. Based on the current numbers, we feel comfortable concluding the company has passed this first screen.

Screen #2: Does the company’s market capitalization exceed at least $1 billion?

This is a simple screen. Essentially, we are only interested in companies that have a market capitalization of at least $1 billion. Larger companies typically control larger market shares and are less susceptible to technological shifts and competitive forces, such as, for example, the sudden entry of a new major competitor or substitute product. Ross Stores’ capitalization at the end of 2019 was $34.1 billion.

Screen #3: Does the company have strong, upward trending and predictable earnings?

Our third screen requires that the company have strong, upward trending and predictable earnings per share. This screen is critical as earnings are the primary driver of company value. When earnings rise, stock prices are almost always soon to follow. When they drop, normally so do the stocks.

To determine whether the company's earnings per share are sufficiently strong, we determine the level of earnings in each year that corresponds with a return on investment of 12%. If the company has been able to meet the minimum earnings requirement 75% of the time, then it will pass the first component of this screen. Ross Stores has been able to meet the minimum earnings requirement 97% of the time.

Next, we want to see that the company's earnings per share are trending upward. In Ross Stores’ case, its long-term earnings trend has been positive, with earnings per share growing by 10,550% over the last 30 years. It's short-term earnings trend has also been positive with earnings per share rising by 20% over the last two years.

The last component of this screen relates to the stability of the company's earnings. We measure the stability in the company's earnings by calculating a 10-year trailing coefficient of determination, or R-Squared. This indicator measures how tightly trending earnings per share is around a straight line projection. We require a score of at least 0.85 to pass this component of the screen. Ross Stores’ 10-year trailing R-Squared is currently 0.95.

Screen #4: Does the company have a manageable level of debt?

The company that we want to invest in should have limited financial leverage. Companies that exhibit high leverage tend to be more risky than those with low leverage, all else equal. We assess leverage through the use of the adjusted debt-to-income ratio. Companies that are over 10 times on this metric, we rate as having high leverage and high financial risk. Companies that have less than 5 times, we rate as having low leverage and low financial risk. Ross Stores’ debt-to-income ratio is currently 0.2, which is lower than our accepted threshold of 10 times.

Screen #5: Does the company trade at a stable price-earnings multiple?

The company that we want to invest in should also trade at a stable price-earnings ratio. To assess the stability at which the company's multiple trades, we evaluate the historical trend in the company's price-earnings and then establish what we consider an acceptable value range. This can be done in many ways. For our purposes, we use the interquartile range.

Provided that the company's price-earnings has not strayed from this acceptable range more than 10% of the time over its 30-year operating history, we would consider the ratio to be relatively stable. Ross Stores' price-earnings ratio has trended outside the acceptable range 0.0% of the time.

In addition to wanting to see stability in the price-earnings ratio, we want to see that the company is trading at an acceptable level relative to earnings growth. The PEG Ratio (price-earnings to growth ratio) is the valuation metric we use for determining the relative trade-off between the price of a stock, the earnings generated per share and the company's expected growth. Ross Stores’ price-earnings ratio is currently 25.2. The market's consensus three- to five-year earnings per share growth estimate is 11.5%. This translates into a PEG ratio of 2.2.

Screen #7: Is the company suffering from any recent value-breaks?

Our last screen involves conducting value-break tests. First, this involves assessing whether the company's trailing 12-month earnings trend has displayed any consecutive three-quarter drops over the last 20 years, with a particular emphasis on the last two years. The more consecutive three-quarter drops experienced over a 20-year period, the more unstable the company's earnings stream. And consecutive three-quarter drops over the last two years is a strong signal to exit the stock.

Ross Stores’ trailing 12-month earnings per share has declined by three consecutive quarters zero times over the last 20 years and zero times over the last 2 years. We believe the retailer has passed this first value-break test.

Pricing the company’s stock

The key component of the earnings calibration model is the calculation of the rate of calibration. This is the rate at which a company's earning per share and, as such, its stock price is expected to appreciate or depreciate over the next eight quarters. Estimating the rate of calibration is done using weighted linear regression and is calculated in six steps:

Build the company's 20-year historical earnings per share (trailing 12-mont) chart.
Overlay the company's 20-year historical high-low stock price line.
Using linear regression, calculate the company's six-quarter, three-year, five-year, 10-year, 15-year and 20-year historical earnings per share trend lines.
Extrapolate each historical earnings per share trend line forward eight quarters.
Using each extrapolated trend line, calculate a weighted moving average earnings per share trend line, applying the most weight to the six-quarter trend line and the least weight to the 20-year trend line.
Calculate the growth rate implied by the company's weighted moving average earnings per share trend line. This implied growth rate represents the company's rate of calibration.

The figure below presents our eight-quarter forward projections based on data covering each period of the valuation as well as our weighted moving average projection line.

Walking through the figure, it is clear that projections based on the company's long-term earnings per share trend line are upward sloping. Projections based on the earnings per share trend line from the last 10 years are more steep, reflecting a higher pace of growth relative to the longer-term trend. Based on the data from the previous six quarters, the projected slope of the earnings per share line appears to have increased. Considering all projections, we have derived a rate of calibration of 2.2%.

With the rate of calibration calculated, the company's stock price can be easily estimated by extrapolating the stock price forward eight quarters at the rate of calibration, starting from the last reported quarter's closing price. Doing this produces a stock price estimate of $110.02.

Next, we need to set a valuation range around the price target to facilitate the comparison of the company's current stock price and return potential. To determine the valuation range, we bound the price target by the 10-year average stock price trading range, representing the stock's normal volatility. The span between the upper and lower valuation lines represents the stock's fair value range and indicates where you can expect the stock to trade fairly over the next eight quarters, given the company's earnings history and forward trajectories.

In the figure below, Ross Stores’ valuation range is calculated to be between $102.51 and $117.54. With Ross Stores’ stock currently trading at $98.41, we set an accumulate rating on the company's stock and expect its price to appreciate by 11.8% over the next eight quarters.

Ross Stores is by far one of the best retail stocks we have found and believe it qualifies for investment.

Disclaimer: We do not currently hold any long or short positions in the stock.