Editor's note: The original article contained a gross margin number that did not reflect a change in accounting by the company in FY 2002. We regret the error.
Yesterday, Ross Stores (Nasdaq: ROST ) reported third-quarter earnings in line with consensus analyst expectations. Net sales were $1.4 billion, up 10% from $1.2 billion in the year-ago quarter. Both gross and operating margins improved by 40 basis points. Results were helped by a 4% increase in same-store sales and hurt by a $3.2 million charge for stock options not accounted for in the 2005 third quarter. Earnings per diluted share, buoyed by share repurchases, were $0.31, up 24% from $0.25. The share count was reduced by 3.7% over the past nine months.
With positive earnings and a strong rebound in the share price from the lows in August, one might assume that things are hunky-dory. But I'm concerned about the long-term deterioration of the off-price retailer's margins, because lower margins are never positive for a company's share price. We might already be seeing the effects; even with the recent rebound, Ross still trades below its peak in early 2004.
The good news? Even with falling margins, Ross's economics remain positive. The company continues to generate positive free cash flow, which tallied $149 million for the past nine months. Furthermore, continued increases in same-store sales have helped to maintain the company's operating leverage. Unfortunately, these results will continue to attract competition and put pressure on Ross's profits.
The competition isn't just from TJX Companies (NYSE: TJX ) , the operator of T.J. Maxx, Marshalls, and Bob's Stores, and Stein Mart (Nasdaq: SMRT ) . Ross faces a potential dwindling supply of discounted goods, because its vendors have become more efficient with their inventories. The combined result is a slide in the company's gross margins, from 25.6% in 2000 (after accounting for the reclassification of what goes into cost of goods sold in FY 2002) to 21.8% for the past nine months. To be fair, management has been able to offset some of the drop in gross margin with lower operating expenses.
The bottom line is that Ross has a good business model that continues to grow and create value for its shareholders. However, as a long-term investor, I would keep an eye on those profit margins as a marker for the company's ability to continue to create value.
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Fool contributor Matthew Crews welcomes your feedback -- really! He has no financial position in any of the companies mentioned. The Motley Fool has an ironclad disclosure policy.
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