Is the Law of Large Numbers Finally Catching up with Ross Stores?

Erstwhile high-flyer Ross Stores has disappointed its investors for the second quarter running. The recovering economy is partly to blame for this, as is the company's blistering past growth rate, which will be difficult to sustain over the long-term.

Mar 7, 2014 at 4:07PM

Ross Stores (NASDAQ:ROST), the second-largest off-price retailer after TJX Companies (NYSE:TJX), posted yet another disappointing quarterly result for the second straight quarter. The giant retailer's revenue fell from $2.76 billion in the fourth quarter of 2012 to $2.74 billion. Its net income fell by a worrying 7.6% from $236 million last quarter to $218 million, which comes out to $1.07 per share. Ross Stores has enjoyed a long stretch of good results, and its latest result could be dismissed as a statistical aberration...however, this is the second straight quarter in which the firm failed to meet its targets.

Although the company beat the consensus estimates for both revenue and profit in the third quarter of 2013 with its overall sales growing by a healthy 6% and same-store sales growing by a modest 2% during the quarter, this same-store sales growth represented a big decline from the 6% reported for the year-ago comparable quarter.

Even though Ross Stores can blame the effect of the government shutdown on its highly macro-sensitive, lower-income customers for its dismal performance, its retailing peer Costco (NASDAQ:COST), and even perennial laggard J.C. Penney (NYSE:JCP) escaped the situation unscathed. Costco's net sales for its first quarter of fiscal 2014 jumped by 5%, with comparable-store sales improving by 3%. J.C. Penney confounded even its worst critics after the beleaguered retailer posted better-than-expected results.

What is ailing Ross Stores? 
Ross Stores has had an impressive run of mid-single-digit comps gains since 2008. However, the blistering growth seems to have slowed down considerably recently. In the third quarter, the company issued comps guidance of 2%-3% but comps came in at the lower end of that forecast.

In its latest earnings call, the company lowered its comps growth projection even further to 1%-2% and lowered its full-year earnings projection to $4.05-$4.21.

Ross Stores' Achilles' heel seems to be its over-reliance on price-conscious middle-class customers. Ross' close competitor, TJX, did not fare much better either. TJX recorded mixed fourth-quarter results as sales at stores that were open for at least one year climbed by 3% while the company's revenue declined by 4%. These results can be explained similarly since TJX marks down its merchandise heavily, by 20%-60%, in comparison with department stores and specialty retailers.

Hundreds of buyers from Ross Stores and TJX scour the market in search of manufacturer overruns, order cancellations, and closeouts so they can buy goods at dirt cheap prices. These retailers then pass the huge cost savings to their customers.

Ross Stores and TJX benefit when times are bad since thrift-minded shoppers flock to their stores to hunt for marked-down clothes. Price-conscious middle-class customers also come in droves to hunt for brand-name items at throwaway prices.

The rebounding U.S. economy may, ironically, be working against these companies. Lower-end customers might still stick with these two retailers, but middle-class customers frequently shift to other normal-priced retailers, or even luxury retailers, when the economy rebounds. This negatively impacts the top-lines of these two companies.

In sharp contrast, Costco targets higher-end customers and concentrates most of its stores in higher-income neighborhoods.The warehouse retailer also requires shoppers to register as its members first before they can shop at its stores. A regular member pays a $55 annual membership fee, while an executive member is required to fork out $110.

The membership fee serves Costco in two ways. The first is that it Costco's executive members spend heavily in its stores, contributing two-thirds of its revenue despite making up just over a third of its total members. Its executive membership base has been growing faster than that of regular members, which is great for its revenue growth. The company also collects billions of dollars in membership fees every year, which provides a great boost to its bottom line.

J.C. Penney is a good turnaround bet
Meanwhile, J.C. Penney looks like it's finally getting its turnaround strategy right this time around. The company finished the year with total available liquidity in excess of $2 billion. Although its sales fell from $3.88 billion in the fourth quarter of fiscal 2012 to $3.78 billion last quarter, it announced that it expects comps of 3%-5% in the current quarter. Fourth-quarter gross margin also improved considerably by 460 basis points over the year-ago quarter, from 23.8% to 28.4%.

J.C. Penney's historical gross margin resides north of 37%. The recent fall is a result of the company's extensive product markdowns as it tries to get rid of unwanted merchandise from the Ron Johnson era. This margin is quite likely to gradually tick up once the unwanted merchandise is removed, but it is unlikely to hit its historic highs soon since the company is keen on keeping customers coming back by offering low prices.

The fact that investors bid up J.C. Penney's shares by a massive 25% in a single day after the results were released is a good sign that many expect the company to succeed in its turnaround bid. It should.

Foolish bottom line
Ross Stores' investors have become used to highly impressive growth figures from the company. However, the law of large numbers dictates that any company growing too fast in comparison with its peers will eventually, at some point, experience tapering growth as its growth approaches the industry average. This law might be catching up with Ross Stores. The company is also being negatively affected by the recovering economy as its middle-class customers flee to other retailers.

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Joseph Gacinga has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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