Discount Apparel Retailer's Stock Looking Good at These Prices

Off-price retailers like  Ross (ROST) have increased their customer bases throughout the recession and weak recovery. This has come largely at the expense of other apparel retailers, with same-store sales in our department store coverage universe falling an average of 5% in 2012 compared with a 6% same-store sales increase for Ross. We think consumers have become more price-oriented and willing to trade customer service and an expensive store design for 20%-60% discounts on the same brand-name merchandise. With economic headwinds likely to persist over the near term, we think Ross will maintain its new market share and benefit from suppliers' excess inventory. That said, we also believe that this model will work in a positive economic environment.

With consumers remaining steadfastly focused on value, Ross reported a strong second quarter, its strength spanning revenue growth, merchandise gross margin, and expense control. Management raised full-year earnings-per-share guidance to a range of $4.18-$4.26 (including a one-time $0.02 benefit) from $4.09-$4.21. We think these results support our view that Ross has a narrow moat, its sustainable competitive advantage stemming from its vendor scale, high inventory turnover, ability to buy into trends, and ability to merchandise stores to meet local preferences. Given ongoing consumer value orientation, we think Ross is perfectly positioned to gain market share with its brand-name merchandise at a discount. We see little change to our $80 fair value estimate, as the results support our expectation for 7% compound annual revenue growth and slight margin expansion over the next five years. We think shares are undervalued and would be buyers of the stock.

Consumers responded positively to Ross’ merchandising with sales up 7% during the quarter, aided by a 2% increase in comparable sales. Management highlighted Juniors as a consistently strong business and Home as one that looks well positioned for the back half and gift giving. Merchandise margin expanded by about 35 basis points due both to higher markup and lower markdown, which we see as a testament to improved buying and inventory control. This, in addition to tight expense control, improved freight and buying costs, and a benefit from settlement of a legal matter, contributed to an operating margin increase of 70 basis points to 14.3%. We think continued tight inventory management (average in-store inventories were down about 2%) will yield a large opening to buy and the ability to chase demand, thereby aiding sales and merchandise margins. However, second-half earnings will be affected by interest and occupancy costs associated with the New York buying office and a new distribution center.

Ross' Superior Scale Earns It a Narrow Moat
We have awarded Ross Stores a narrow moat rating because we believe that success in the off-price retailing model requires significant scale to support a large buying force, warehousing, and distribution. Additionally, Ross' proprietary inventory management system allows for merchandise to be differentiated for local preferences, providing a powerful intangible asset and thus enabling the company to target a broad market. As such, we think it is slightly protected from the intense competition of more traditional retailers and can sustain higher-than-average growth.

Ross management has stated that it believes the U.S. market could support the current store count doubling. Our channel checks support this thesis. Long lines and quick inventory turnover indicate that even current markets offer the opportunity for additional growth. Management has strategically executed its growth strategy, opening clusters of new stores in markets to take advantage of operational efficiencies.

We view Ross as a compelling long-term idea in the apparel retail space. Over the next five years, we think Ross can achieve 7% average annual revenue growth on 2% comparable sales and a 7% increase in stores. We expect improved inventory management to yield an average 1% increase in annual operating margins. That said, near-term performance may be more limited by an increasingly cautious core consumer and a learning curve in new Midwest markets.

Ross' Admirable Position in the Competitive Apparel Retail Space
The apparel retail space is characterized by low barriers to entry and intense pricing competition, exacerbated by the heavy economic pressures facing consumers. However, it is an environment in which Ross Stores has managed to thrive. With the exception of one quarter, Ross has posted flat or positive same-store sales growth since the beginning of fiscal 2008. We think this consistent outperformance is an indication that the company has managed to dig itself a moat in the apparel retailing space via cost advantages.

The off-price retailing space has made significant inroads during the recession and slow recovery, with total aggregate sales for the five largest off-price U.S. retailers increasing 11% in 2012 versus a 4% increase for total national apparel sales (according to NPD Group and Ross Investor Presentation). But despite its appeal, it is not an easy space for new entrants to invade, giving off-price retailers a sustainable cost advantage. Much of Ross’ success is due to its significant buyer fleet, with about 600 merchants scouring almost 8,000 vendors for attractively discounted designer staples and inventory reflecting the season’s hottest trends. With four distribution processing facilities and two more in the pipeline, the company can get the right merchandise to the right store at the right time in a cost-effective way. Five warehouse facilities enable the company to take advantage of deep discounts on designer staples at each season’s end and to store them until the next season. Investments in planning and allocation have reduced markdowns and increased inventory turns. Ross had only 63 days inventory outstanding in 2012 versus the department store average of 90 days. We think that this level of inventory control benefits the company in numerous ways. First, constant inventory replenishment increases the number of visits per customer. Second, it reduces the need for end-of-season markdowns. Third, it decreases the capacity requirements for inventory storage.

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Because scale is essential to success, there are few players in the space, and some, such as Filene’s Basement and Syms, could not survive. Although  TJX Companies (TJX) is the largest corporate entity in the space, with about 3,100 stores spread worldwide and under various brand names, Ross is the largest single brand in the U.S., with 1,131 stores. TJ Maxx trails this store count with 1,052 stores, and Marshalls ranks third with 914 stores.  Big Lots (BIG) boasts 1,400 retail stores but is not focused on apparel and instead focuses on a broad assortment of merchandise, including consumables, seasonal products, furniture, housewares, toys, and gifts. Other specialty apparel stores, such as  Kohl's (KSS),  H&M (HM B), and Zara, offer attractive prices but not the same designer names that can be found at Ross. We think there is more than enough room in the market for two or three large competitors and think that Ross’ scale will allow it to continue to offer better prices and merchandise than small market entrants can.

Ross' narrow moat rating is based primarily on the cost advantages inherent in its scale. We expect the company to continue to post above-average revenue and EBIT growth for at least the next 10 years and are modeling a five-year average annual ROIC of 19%, well above the 10% cost of capital used in our discounted cash-flow analysis. Although we are comfortable with projecting 10 years of above-average returns, we do acknowledge that other competitors may scale over time and become a threat. As such, we are not giving the stock a wide moat rating.

Ross' Capable Management Team Has All the Right Experience
The Ross management team has extensive retail experience, both within and outside of the company. Barbara Rentler was appointed CEO and a member of the board in June 2014. Although new to the position, she is not new to the company. From 2009 to May 2014, she was president and chief merchandising officer of Ross Dress for Less, and executive vice president, Merchandising, from 2006 to 2009. She also served at dd’s DISCOUNTS as executive vice president and chief merchandising officer from 2005 to 2006 and senior vice president and chief merchandising officer from 2004 to 2005. Prior to that, she held various merchandising positions since joining the company in 1986.

Michael Balmuth served as the company’s CEO from 1996 to 2014 and is now continuing his service as executive chairman of the board. The CEO’s compensation for 2013 totaled approximately $6 million, including a base salary of $1.3 million, stock and option awards of $3 million, incentive plan compensation of $1.8 million, and $87,000 in other compensation. We think this is roughly in line with industry norms. The 10-member board is composed of Rentler, Balmuth, and six independent directors. With this high level of independent participation, we consider this corporate governance structure to be fair. Collectively, insiders and 5% of owners control 3% of the equity, with institutional and mutual fund owners composing 89% of ownership. The number of institutions that hold an interest in the company is 587, with Vanguard, FMR, and T. Rowe Price holding more than 5% of shares outstanding, so we are pleased with the diversity of ownership. Management has actively participated in shareholder-friendly activities in the form of dividends and share repurchases.