I like to invest in businesses with powerful, enduring competitive advantages. But so does everyone else, which means that the stocks of such companies are rarely undervalued. Thus, I'm willing to consider good but not great businesses if the price is right.
In this category, my favorite kind of investment is buying a solid company whose stock has been crushed because it's in an out-of-favor sector. Ross Stores (Nasdaq: ROST) -- commonly known as Ross Dress for Less -- fits the bill perfectly. I discovered the company in January and accumulated a substantial position that I've been adding to in the past week as the stock has gotten whacked again.
While discount apparel retailing is a tough industry, and it's hard to argue that Ross has much of a moat around its business, the company's management has been executing superbly for many years and is very shareholder-oriented, the business has surprisingly good economic characteristics, and the stock is dirt cheap.
Ross is the country's second-largest off-price apparel retailer after TJX Cos. (NYSE: TJX), which owns Marshalls and T.J. Maxx. Ross has 385 stores in 17 states, with 70% in California (162 stores), Texas (55), and Florida (52). Ross is the dominant off-price apparel retailer in 12 of the 17 states in which it operates. Ross targets middle- to upper-middle-income women ages 25 to 54, and offers, according to its annual report, "first-quality, in-season, name-brand apparel, accessories and footwear for the entire family at everyday savings of 20% to 60% off department and specialty store regular prices."
So how does Ross make money selling name-brand merchandise at such low prices? By opportunistically buying in-season close-outs and "packaways" at enormous discounts. Packaways, which accounted for 44% of Ross' inventories at the end of 1999 (in line with historical levels), mean that Ross buys merchandise at the end of a season and stores it for six to nine months and then sells it during the next season.
Given what a difficult industry Ross operates in, its economic characteristics are very impressive. Here are the highlights:
- Revenues have grown every year since 1987, and have compounded at 12.9% for the past 10 years and at 14.4% for the past five years.
- Ross hasn't lost money since 1986 and earnings per share have grown every year since 1993. Over the past five years, EPS has compounded at a remarkable 40.5%.
- Gross and net margins have grown every year since 1994, increasing from 27.1% and 2.9%, respectively, to 31.4% and 6.4% in the latest quarter.
- Over the past five years, sales per square foot have grown from $227 to $300, a 5.7% compounded annual increase.
- Return on equity has increased from 15% in 1994 to 33% each of the past three years. Over the same period, return on assets has grown from 8% to 17%.
- Ross' Flow Ratio is 1.26, at the low end of the range for the past 10 quarters (1.23 to 1.49). A Flowie of 1.26 is good for a retailer, especially one that relies on packaways, which increase inventory levels.
- The company was debt-free since 1996 through last quarter, when it took on a small amount of long-term debt -- $20 million, alongside $33 million of cash. (Note that like most retailers, Ross has substantial lease obligations, which totaled a minimum of $841.6 million at the end of fiscal year 1999.)
- Many retailers show a profit on the income statement, but actually generate little or no free cash flow (cash flow from operations minus capital expenditures) due to increases in working capital and capital expenditures necessary to fuel growth. Ross, however, has grown its cash flow from -$6.9 million in 1994 to $109.4 million in 1999. And 2000 is off to a strong start, as Ross generated $16.7 million of free cash flow in Q1 (February through April) vs. -$26.5 million in the same quarter last year.
- Finally, Ross is using its robust free cash flow to fund an enormous share buyback. On February 3, Ross announced that "its Board of Directors approved a new stock repurchase program authorizing the buyback of up to $300 million of the company's common stock over the next two years. At current market prices, this authorization represents around 25% of the company's issued and outstanding shares." Ah, but lots of companies announce big share buybacks and don't follow through, right? Not Ross. So far, the company is overdelivering on its promise. In only four months -- from January 31 through May 26 -- Ross' total shares outstanding dropped 6.5%. The result of these share repurchases can be seen in the earnings reports. Last quarter Ross' earnings rose 19% year-over-year, but due to a 8% decline in the diluted weighted average shares outstanding, EPS rose 27%. Nice!
This is a tough business. There's no question that it violates Peter Lynch's rule about buying businesses that any idiot could run, because someday, some idiot will. If an idiot were running Ross, it would be road kill in short order.
But Ross has a very stable management team that has successfully guided the company for many years. The CEO, Michael Balmuth, has been with the company since November 1989 and has been in his current position since September 1996. Of the 10 senior managers, only two have been with the company less than seven years, and the three general merchandising managers -- a key role in this business -- have all been with Ross for at least seven years.
Ross' growth strategy is to continue increasing both its store base and same-store sales. Over the past five years, both of these measures have increased at a 7% annual rate, resulting in 14% compounded sales growth. Going forward, Ross plans to build 30 new stores this year (seven have already opened), 35-40 new stores in 2001, and 40-50 in 2002 -- a steady annual increase of 10% or so. Approximately one-third of the new stores in 2001 and 2002 will be in the Southeast, where Ross plans to expand from its base in Florida to Georgia, North Carolina, and South Carolina. Ross believes there is the opportunity to expand to about 600 stores nationally over the next five years.
Ross also plans to continue expanding its merchandise beyond apparel into higher-margin areas. The "home accents and bed & bath" category has grown from 3% of sales in 1993 to 16% in 1999, and "accessories, lingerie, fine jewelry & fragrances" accounted for an additional 12% of sales last year. Ross is rolling out jewelry in 85 stores this fall.
What's Wrong With the Stock?
In the past month, Ross' shares have fallen more than 30% from around $24 to under $16. Two factors appear to be driving this. First, the stocks of many retailers are dropping due to fears of a general economic slowdown. Second, Ross reported same-store sales in May of 3% vs. the company's projections of 5-6%. Gee, that's worth taking a stock down 30%, right?
I see six primary risks facing Ross -- four external and two internal. First, if the economy does in fact tank, then Ross' growth and profitability would likely be impaired. Second, if full-price department stores in Ross' regions slash prices for some reason, they would likely draw customers away from Ross. It was their aggressive couponing in December that led to Ross' flat same-store sales, which triggered a 28% drop in Ross' stock in only nine days. (These two risks are the ones that most concern the company, according to a spokesperson.) Third, I've seen evidence that America in general is over-retailed, and the discount apparel sector is no exception. Overcapacity leading to a shakeout in the sector might hurt Ross. Fourth, Ross does not have an online presence, nor is one imminent. I question whether people will ever buy the type of merchandise Ross sells over the Internet, but I've been wrong before.
The final two risk factors are within Ross' control. First, bad execution -- for example, its merchandisers stocking up on fashions that don't sell well the next season -- could hurt Ross. Second, Ross' expansion into new geographic and merchandise areas carries some degree of risk.
While Ross has demonstrated very steady, robust growth over the past five years, let's not confuse Ross with a genuine growth company like Cisco or Pfizer. From 1989 to 1994, Ross' EPS was $0.31, $0.18, $0.27, $0.33, $0.29, and $0.31. Could Ross repeat this erratic performance? I don't think it's likely, but the market seems to think so, given where the stock is priced today.
How Cheap Is Ross?
As I write this, Ross is at $15.50 per share, equal to 8.6x trailing 12-month EPS of $1.80 (excluding a one-time charge for a legal settlement), and 7.6x consensus analyst estimates of $2.04 for this year. Any way you cut it, that's cheap, especially in today's richly valued market.
To put Ross' price in perspective, I did a search through Value Line's CD-ROM database of more than 5,000 stocks and searched for all companies with at least 15% EPS growth over the past five years and projected for the next five years, 15% or higher return on equity, and more cash than debt on the balance sheet. Fifty-six companies met these criteria, including a number of retailers such as Dollar General, Williams-Sonoma, Best Buy, and Bed Bath & Beyond. Not surprisingly, most of these 56 companies are very richly valued. Only eight trade at P/E ratios of less than 20 and only five at less than 10: Ross; Micros Systems (a supplier of information systems to the hospitality industry -- the stock is down more than 50% in the past month on an earnings warning); Winnebago and Thor Industries (both are motor home manufacturers); and Trans World Entertainment (the largest music retailer in the U.S., which owns Record Town, Coconuts, and Strawberries, among others). Compared to these other four companies, Ross' historical performance has been steadier and its future outlook, in my opinion, is much clearer.
Another way to look at Ross' price today is to project the returns one might expect to earn over the next five years from buying the stock today. If we assume an 8% annual increase in stores (the company projects 10%) and a 3% annual increase in same-store sales (significantly below the 7% of the past five years), this yields a 10% annual increase in revenues (not 11% since new stores take a while to become as productive as old ones). Assuming the flat margins that Ross projects, the bottom line would also grow 10% annually. I think this is quite conservative given that stores, same-store sales, and margins have all grown significantly faster than these projections for many years.
With share buybacks, Ross' EPS growth should at least match analysts' projections of 15%, so the final piece of the puzzle is the P/E ratio. Given its already depressed level, I think it's unlikely that Ross' P/E multiple will drop over time. In fact, if Ross maintains its margins, growth, and clean balance sheet, I think its P/E could be 13-15, about where it was only a month ago. Putting all this together yields a good chance of 20-25% annual returns for the next five years. I'll take that any day.
-- Whitney Tilson
Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous guest columns in the Boring Port and other writings, click here.