In June, I wrote a bullish column on Ross Stores (Nasdaq: ROST) based on my belief that the stock was substantially undervalued despite recent difficulties. Even weak Q2 earnings didn't change my opinion materially. But, subsequent news has been quite disappointing, leading me to conclude that the stock, while still attractively priced, is not as undervalued as I once believed.

Q2 Results
Ross reported Q2 earnings in mid-August that matched reduced analysts' estimates of $0.43 per share. Due to "a softening in consumer spending and a more promotional climate," net income declined 7.0% year-over-year, despite a 6.9% increase in sales. Earnings per share, however, rose 2.4% due to a 9.9% decline in the number of shares outstanding.

These results were what I expected and didn't especially concern me -- and I really liked the big share repurchases. What does concern me, however, are declining cash flows, rising debt, diminishing share repurchases, and continued weak sales in August.

Cash Flow
On net income of $35.9 million, Ross' cash flow from operations was only $5.8 million, a troubling gap. A quick look at the balance sheet reveals the culprits: "accounts payable, accrued expenses and, other" fell by $25.7 million, and inventories rose by $22.0 million in Q2 versus Q1 (a 4.0% increase; year-over-year, inventories rose 10.5%, slightly faster than sales). This more than accounts for the $30.1 million difference between net income and cash flow from operations. The company did note, however, that inventories are rising due to new store openings (seven in July alone and 20 planned for Q3, versus only seven in the entire first quarter). Same-store inventory levels actually fell 2% year-over-year.

For the quarter, capital expenditures were $21.0 million, yielding free cash flow of negative $15.2 million. These results are much worse than comparable numbers in Q2 1999. In that quarter, on $38.6 million of net income, Ross generated $46.7 million of cash flow from operations. Capital expenditures were $18.2 million, yielding free cash flow of positive $28.5 million.

The company commented that it focuses on year-to-date cash flows, not quarterly ones, which can be affected by timing issues. Using this approach, the story improves markedly for Ross, as Q1 2000 was much stronger than Q1 1999. In total, for the first six months of each year, free cash flow was $2.0 million in 1999 versus a nearly identical $1.5 million in 2000. This is a valid way to analyze the situation, but I still don't like the trend.

Debt
Another area of concern is Ross' rising debt level. Keep in mind that Ross, like most retailers, is already leveraged via its lease obligations, which totaled a minimum of $841.6 million at the end of fiscal year 1999. Thus, I don't like to see meaningful debt on top of this.

Historically, the company has done seasonal borrowing during the year, peaking in Q3, as it ramps up for Q4, where it generates nearly all of its free cash flow for the year. Ross then pays off its debt and has ended every year since 1996 debt-free. This chart shows Ross' total debt levels by quarter for the past 10 quarters:

Ross Stores' Short-term Plus Long-term Debt (millions)

          2000     1999      1998
Q1        $20        $0        $0
Q2        $80       $17       $38
Q3                  $53       $74
Q4                   $0        $0
I'm concerned that the first two quarters of this year show higher debt levels than the comparable quarters in the previous two years. The extra debt isn't excessive for a company that generated more than $150 million of net income and $109 million in free cash flow last year, but the Q2 jump -- primarily to fund Ross' share repurchase program and cover the negative free cash flow (plus an extra $12 million of cash) -- is more than a rounding error, and I don't like the trend.

Share Repurchases
After spending $99.4 million to repurchase shares in Q1 (part of a $300 million, two-year repurchase program), Ross only spent $28.4 million in this area in Q2, and said in its earnings release that it expects "to buy back more than half of the two-year $300 million authorization during this fiscal year." That's a commitment for only another $22.4 million over the next two quarters ($150 million minus $127.8 million spent to date).

Given its weakening cash flow and rising debt, I don't fault Ross for scaling back its share repurchases, but it means that the big boost to EPS that we saw in the first two quarters is likely to diminish going forward. The company commented that "the number of shares we repurchase the rest of this year will depend on our cash flows."

Weak Sales
Ross recently reported that same-store sales in August fell 3%, continuing a weakening trend. Here are the monthly same-store sales over the past two years:

            2000    1999
January      7%      8%
February     8%      9%
March        3%      9%
April       11%      3%
May          3%      8%
June        -1%      7%
July        -2%      7%
August      -3%      7%
September            8%
October              4%
November             3%
December             0%
The past few months have been ugly, and it can't be blamed on tough year-over-year comparisons. The decline is broad-based, both geographically and by product category.

What's going on? In reporting its August numbers, Ross' CEO said, "We believe that our business in August continued to be impacted by a more competitive climate compared to last year, especially from the department store sector." In short, weakening consumer spending is hitting the entire retail sector, which hits Ross directly and also causes its department store competitors to become more aggressive on price, reducing Ross' value proposition. That's a tough double whammy.

Consequently, Ross' CEO has reduced future guidance again: "Looking ahead, we are maintaining our cautious outlook for the balance of 2000, particularly since the environment remains difficult to predict, and the softening in our sales momentum continues to pressure both gross margin and expense ratios. As a result, if same store sales for the balance of the current year perform in line with the recent trend of flat-to-down-3%, we now expect earnings per share to be in the range of $0.33 to $0.36 for the third quarter and $1.75 to $1.85 for fiscal 2000. The company reported earnings per share before non-recurring legal costs of $0.38 and $1.70 for the 1999 third quarter and fiscal year."

Conclusion
With Ross trading at approximately nine times this year's recently lowered expected earnings, I believe that the concerns I've cited above are priced into the stock, and any positive news whatsoever could send the stock soaring, so I'm content to hold a modest position. This remains a solid, well-managed company with many attractive characteristics that I highlighted in my earlier column.

However, given the factors I've cited above, I no longer believe the stock is hugely undervalued -- only somewhat undervalued -- so I have sold my highest-cost-basis shares that I bought in the $15-$16 range. If the stock falls back into the $12 range where I first bought it in January, I might add to my position.

-- 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.