January 19, 2022

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Paused for the Pandemic, but the Future Is Promising

“Obviously, with Ross’s stores closed, demand will be running at zero for the moment, but developments in the apparel supply chain should create a very favorable environment for it when business reopens and heads toward normalization.” – David Rolfe (Trades, Portfolio), April 7, 2020

David Rolfe (Trades, Portfolio) wrote those words in the Wedgewood Funds’ first-quarter 2020 shareholder letter, explaining why he thought Ross Stores (NASDAQ:ROST) still had potential, even though he was eliminating it from his funds. He said they pulled out of the stock because it had reached its full valuation (before the slump began) and that they wanted capital for “better ideas”.

For those who like to buy their straw hats in winter, Ross may be a fit. Because of Covid-19 restrictions, its stores are closed and its first- and second-quarter results will be dismal. But once they fully reopen, business should be brisk. And once it is business as usual again, its stock price should rise above its current depressed level.

The company describes itself this way in its latest 10-K (filed on March 31):

“Ross is the largest off-price apparel and home fashion chain in the United States, with 1,546 locations in 39 states, the District of Columbia, and Guam, as of February 1, 2020. Ross offers first-quality, in-season, name brand and designer apparel, accessories, footwear, and home fashions for the entire family at savings of 20% to 60% off department and specialty store regular prices every day. Ross’ target customers are primarily from middle income households.”

It also operated 259 dd’s Discounts stores that offer more moderately priced clothing to customers who have more moderate incomes than Ross customers.

The corporate strategy has been successful, with years of growth that produced this price chart:

GuruFocus Ross Stores price chart

And, what about the danger from online vendors, including the mighty Amazon.com Inc. (NASDAQ:AMZN)? As Steven Chen pointed out in his article, “The Amazon-Poof Retailers,” Ross is one of a limited number of companies that has been challenged by online juggernauts and survived. He wrote, “What is important here is that off-price retailers offer a discovery-based ‘treasure hunt’ experience that is difficult to imitate online, making the physical store a compelling atmosphere for their target customers. This is why industry leaders like The TJX Companies (NYSE:TJX) and Ross Stores shrugged off competition from e-commerce players and earned high returns on capital for their shareholders year after year.”

This implies that Ross has an economic moat, or competitive advantage, that protects its margins and, ultimately, its profits. To quantitatively test that, we turn to the Macpherson model, which includes measures of competitive advantage as well as financial strength, profitability and valuation.

Moat

The model uses two criteria to measure moats:

  • A return on capital median of at least 15% over the previous 10 years. Ross passes that hurdle easily at 34.53%; that’s also 5.7 times as much as the company’s weighted average cost of capital. Put another way, it means Ross has been generating $5.71 in returns for every $1 invested through debt or equity.
  • A return on tangible equity median of at least 15% over 10 years, as well. Ross’s lowest ROTE in the past 10 years was 42.82%, so it easily passes this hurdle as well.

Financial strength

In this category, the Macpherson model looks for a cash-to-debt ratio of 100 and an overall rating of at least 9 out of 10. This excludes most if not all companies with debt.

On the first metric, Ross has a cash-to-debt ratio of 0.39, so it is far below the threshold. On the second, it receives an overall rating of 7 out of 10, which is below the threshold.

Pulling the company down on these ratings is the existence of debt. However, this is not a company that has borrowed a large amount. Instead, it is a company with a heavy load of long-term capital obligations, not unexpected for a brick-and-mortar retailer. Of the long-term debt and long-term capital obligations of $2.923 billion, only $313 million is actual debt (and it has no short-term debt). And total debt works out to $9.66 per share, while the share price was $84.07 at the close of trading on April 22.

Another metric of related interest is the interest coverage of 220.6, which means there is no danger of a debt crisis for this company. All things considered, I would give Ross a pass on financial strength.

Profitability

As the rating at the top and the swath of green below suggest, Ross also gets a pass on profitability:

GuruFocus Ross Stores profitability table

Valuation

Because of the current stock market slump, Ross is now on the Undervalued Predictable screener list. GuruFocus recommends that we use earnings-based discounted cash flow to value the stock.

According to the DCF calculator, using its default settings, Ross is valued (intrinsic value) at $108.10, which is roughly $24 more than its current price of $84.07. That means the stock has a margin of safety of 22.23%, and we can give the retailer a passing mark for valuation.

On Feb. 24, Ross hit a historic high of $121.62 per share, fell to about $60 and then recovered to the low $80s.

Ownership

The gurus followed by GuruFocus have sold more shares than they’ve bought since 2018, as this chart shows:

GuruFocus Ross Stores guru buys and sells

Ten gurus have holdings in Ross, with two of them holding more than a million shares each. PRIMECAP Management (Trades, Portfolio) held 11.4 million and Pioneer Investments (Trades, Portfolio) held 4.4 million as of Dec. 31.

Covid-19 response

In response to the pandemic, Ross closed all its retail stores on March 20 and furloughed many of its employees. Although the employees may be at home now, the company is taking measures to keep them so it can reopen its stores as quickly as possible once the threat level has been reduced.

It also has taken several measures to cut its costs and maintain liquidity; there’s no word so far on the fate of its dividends, which were last paid on March 31 ($1.14 per share).

Conclusion

Ross Stores was a strong retailer before the current, pandemic-driven crisis occurred with solid returns and a consistently growing stock price. I expect it will get back on track once the pandemic eases, business returns to some sense of normalcy and investors get out of panic mode.

It passed the hurdles in the Macpherson model, with good grades on a competitive advantage, financial strength, profitability and valuation. Given its current price, it is well positioned for investors who take a longer view.

In this case, value investors may wish to look past its debt to see what this company may offer in the next five to 10 years.

Disclosure: This article is only an introduction to the company and investors must do their own due diligence. I do not own shares in it and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.

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