Ross Stores: Valuation Not As Attractive As That Of Its Peers (NASDAQ:ROST) -LSB

Investment Thesis

Ross Stores (NASDAQ:ROST) operates in a sector known for its resilience during economic downturns, making it an attractive choice for portfolio diversification. Despite having some of the best margins in its sector and favorable market conditions supporting it Continuing growth, it appears that the current valuation already reflects these strengths, limiting the potential for attractive returns.

In this article, we will delve into the commendable characteristics of the business and its sector, exploring the reasons for its resilience during crises. Furthermore, I will perform a comparative analysis with its peers and perform an evaluation to prove why I advocate a ‘STAYEvaluation.

Business overview

Ross Stores is a chain of off-price stores and is one of the largest off-price retail chains in the United States. The company operates under two top brands: Ross Dress for less and dd’s DISCOUNT. Ross stores offer a variety of products, including clothing, footwear, home goods and accessories, at discounted prices. As of July 2023, the company operated 1,772 Ross Dress for Less in 41 states in the country and 339 dd’s DISCUNS stores in 22 states, so there are still possible room continue to grow within the United States.

Ross Stores follows a no-price business model, which means they buy goods from a variety of sources, including manufacturers, department stores and other retailers, in one significant discount. They then sell these products to consumers at lower prices than traditional retailers, attracting bargain shoppers. The company has various levers it can use to secure discounts on products. Among them we can single out the following:

• Closure and Closure: Ross often buys merchandise that other retailers, manufacturers, or distributors cannot sell at regular retail prices. This could be due to overstocking, closings, or excess inventory.
• Negotiating discounts: Ross negotiates with vendors, manufacturers, and other suppliers to purchase products at lower prices. They use their position as a large and established retailer to secure favorable terms and discounts.
• Irregulars and seconds: Ross may also purchase irregular or slightly imperfect items that did not meet the original seller’s quality standards. These items are often usable but are sold at a discount due to minor defects.
• End of season merchandise: As fashion seasons change, retailers often have to clear out their inventory to make room for new products. Ross takes advantage of this by buying merchandise at the end of the season at a reduced cost.
• Flexible Merchandising Strategy: Ross maintains a flexible and opportunistic approach to trading. They adapt to market conditions and take advantage of buying opportunities as they arise, ensuring a constant flow of new and diverse products.

This strategy has played an important role in the popularity of off-price retailers like Ross, especially among budget-conscious shoppers looking for quality products at discounted prices. This becomes even more important in macroeconomic environments characterized by high inflation or concerns about potential recessions, as is currently the case. Examining the performance of these businesses during crisessuch as the financial crash of 2008, reveals that revenues and margins were not only stable, but also improved. This is because products offered by discount stores are perceived as a means for individuals to stretch their salary.

Not only are we talking about powerful businesses, but the market is also substantial and expected to sustain one annual growth rate of 8% at least until 2028. This growth can be attributed to significant value that users perceive in products, along with “Treasure hunt” shopping experience in these stores.

Key reports and competitors

Ross Stores faces direct competition from two main competitors: TJX Companies (NYSE:TJX), owner of TJ Maxx, Marshalls and HomeGoods and Burlington (NYSE:BURL). To assess Ross’s performance compared to its competitors, we can analyze their respective numbers.

TJX Companies stands out as the competitor with the largest scale, supported by its global presence. When focusing on US operations alone, it maintains its lead with 3,411 stores that include TJ Maxx, Marshalls and HomeGoods.

In contrast, Burlington currently operates on a smaller scale with only 939 stores, indicating significant potential for expansion. Notably, Burlington boasts the highest store growth rate among its competitors. Over the past decade, it has achieved an annual expansion rate of 7%, outpacing both Ross Stores, which grew at 5.2% annually, and TJX, with a growth rate of 4.6%.

The revenue per store of all three ranges around $10 million, so there is not much difference between the profitability of the three.

Ross Stores’ income have grown at a steady annual rate of 7% over the past decade, consistently maintaining average EBITDA margins of 15%. Although not characterized by rapid or exciting growth, the stability and consistency of this growth over time is evident. Furthermore, the continued positive trajectory in the top line is evident, especially considering the company’s existence for over 40 years.

of cash conversion cycle is a metric that reveals how long it takes a company to turn money invested in inventory back into cash through product sales. This metric is essential for evaluating a retail business’s ability to negotiate with suppliers. A company can improve its payment terms by building a strong reputation and achieving a significant sales volume, encouraging suppliers to agree to more favorable terms rather than risk losing an important customer.

In this context, Ross Stores boasts the most favorable cash cycle, with Burlington following closely behind. However, it is important to note that the metric for TJ companies may be affected by its operations abroad, potentially skewing the comparison, but it already gives us an example of how good ROST is for managing your cash cycle and the benefits it can provide. have. on the free cash flow margin.

What was previously mentioned can be observed in Free Cash Flow Limits of each company, as Ross Stores has consistently maintained higher margins since 2015.

Ross’ return on invested capital (ROIC) is typically slightly higher among its peers, which is a sign of good capital allocation and competitive advantages.

ROIC also provides insight into how all companies in the sector have faced challenges in regaining their pre-pandemic profitability since the COVID-19 pandemic. With reduced consumer spending in 2020 and ongoing supply chain disruptions in 2022, full recovery remains elusive. To provide perspective, the average ROIC for the three companies combined was 33% before 2020, but in the last two years it has decreased to just 15%.

In the conditions of debt, the company historically operated with negative levels of net debt, meaning that its cash and cash equivalents on its balance sheet were sufficient to cover its total debt. However, with the onset of COVID-19 and subsequent economic shutdowns, the company had to issue a significant amount of debt.

Specifically, it has gone from a ratio of -0.5 to 0.9, which it has currently managed to reduce to 0.5. It is anticipated that this ratio will continue to decrease, aligning with the company’s strategy of maintaining conservative debt levels.

ASSESSMENT

In evaluating the rating, I will focus on key performance indicators (KPIs) essential for a retail store: the opening of new stores and income increase per store.

Ross Stores has consistently opened stores at an annual rate of 7% over the past decade, with revenue per store showing an increase of 0.6%. However, it is important to acknowledge the impact of 2020 and 2022 on these metrics. If we exclude these years, revenue per store would have demonstrated a stronger annual growth of 3%.

In the majority last conference, the company expressed its intention to open 100 stores this year and I think this trend can go further. For revenue per store, I will take a conservative approach and assume 2.5% growth over the next five years.

Turning to store growth, we opened 18 new Ross and nine dd’s DISCOUNT locations in the second quarter. We are on track to open a total of about 100 locations this year, consisting of about 75 Ross and 25 dd.

This means one Annual revenue growth of 7%. Assuming the company continues to repurchase shares at the 2% rates seen in prior years and margins return to the nearly 16% levels reached before the onset of COVID-19, we can anticipate generating $4.3 billion in EBITDA. Applying multiples consistent with the company’s historical performance and comparable benchmarks, one can expect a projected share price range of US$145 to US$165 within five years. This represents one annual return of 4.7%except for the 1% dividend.

I believe the modest return is attributable to market awareness of the defensive nature of these companies. Currently, there is a willingness to pay nearly 18x EBITDA for the stability these assets provide. However, historically, the average for Ross Stores and TJ Companies has hovered around 10-12x EBITDA. If the economy returns to normal and the market’s perception of fear diminishes, there is the possibility of a rotation away from stable assets to growth or somewhat more speculative stocks. In such a scenariocompanies like ROST may experience a compression in their assessment.

Final Thoughts

Ross Stores has demonstrated its resilience as a highly defensive business, maintaining relevance for many years. Furthermore, the potential for growth looks promising, with room for an increase in the number of stores in the US and possible international expansion, as seen in the case of TJ companies.

However, despite these positive aspects, the current valuation does not offer a compelling return, leading me to advocate for a ‘STAYEvaluation instead of a purchase. And if you are still interested in positioning yourself in a company with these characteristics, similar companies, such as Burlingtonlook more attractive to me currently due to their potentially higher growth and margin expansion.