Ross Stores: Sales Growth Is Expected But Valuation Improvements Is Doubtful (NASDAQ:ROST)

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People shopping at Ross Dress for Less

Sundry Photography/iStock Editorial via Getty Images

Thesis

The Company will succeed in seeing sales growth but is less likely to lead to cash or net income creation. The current macro-economic challenges and cost pressure are expected to offset the positive consumer demands for the Company in the near term.

I am giving a “neutral” view of the current $92-$94 Range price. I recommend that the investors watch whether the operating margin and cash flow can improve, corresponding to its positive sales growth. By then, Ross will be considered more attractive from an investment perspective.

Company Overview

Ross Stores, Inc. (NASDAQ: NASDAQ:ROST), operating under “Ross Dress for Less,” is an American chain of discount department stores headquartered in Dublin, California. It is the largest off-price retailer in the U.S, with 1,923 stores in 40 states.

The Company has two business segments – Ross Dress for Less and dd’s DISCOUNTS. The Company’s business model offers competitive bargains and brings in fresh merchandise to attract shoppers.

Ross Stores’ competitors include Target Corporation (NYSE: TGT), The TJX Companies, Inc. (NYSE: TJX), and Macy’s Inc (NYSE: M).

Financial Results

In the latest earnings call, the Company has shown fast sales growth as the COVID situation begins to phase out. Q1 2022 revenue was $5.02B, an 18% YoY increase.

1. Consumers will look for the products and retail purchases that can save money.

The Company’s demand is in momentum with post-COVID and inflationary pressure. The management mentioned that in 2021, the government stimulus and the lifting of COVID restrictions drove sales growth. The Company also reported $1.04 earnings per share for the quarter, beating the consensus estimate of $0.97 by $0.07.

The increased cost of living and inflationary pressure inevitably reduce consumers’ purchasing power. Consumers are more price-conscious and are attracted to buying name-brand apparel at a fraction compared to shopping in department stores. Low pricing brand strategy for companies like Ross Stores will be able to thrive better in an inflationary environment.

2. Despite the positive top-line growth, the operating margin and cash flow will show slight improvement.

The current macroeconomic challenges are as follows: Ross is not an exception.

  • Extended COVID drives the tight labor market and high wage pressure.
  • COVID mainly drives production delays or cost inflation policies for specific countries like China
  • Energy & food price spikes due to the Ukraine-Russia war, driving higher logistics costs.
  • Overall inflation pressure, driven by the above factors, literally impacts “everything”

The Company must shoulder the cost of inflation, such as wages, product costs, logistics, and fuel costs. Rising expense headwinds are also putting pressure on the Company’s operating margin. The operating margin for Q1 2022 is 9.8%, much lower than Q1 2021’s 15.1%. Due to the Company’s business model and the competitiveness in the retail industry, it will be interesting in the near term to monitor the Company’s strategy to strike a balance between the price increase and still being able to attract and retain customers to spend.

Although the Company has mentioned that the merchandise margin is improving, I question whether that is a valid statement as product cost, logistics, and labor costs are under pressure.

3. An increasing number of store openings, but have to be cautious and monitor consumers’ fashion trends and spending trend

The Company has been increasing the number of stores and seems to be on track for growth. The management mentioned that there had been extensive retail closures and bankruptcies over the last few years. They believe that Ross Dress for Less can expand by 2,900 locations, a 20% increase from the previous forecast of 2,400.

Although the expansionary strategy is excellent news, investors need to be aware of the risk factors. Fashion retail is a highly competitive market, and consumer dressing trends evolve quickly. The more brick-and-mortar stores, the higher impact cost it has to the Company if it cannot keep up with the consumers’ fashion demand and is slow to adjust to their spending trend. Once the consumers deem the Company’s product out of trend, it might take a long while to change the mentality.

Valuation & Conclusion

valuation

Author’s financial model

At the current price of $93.15, I view the Company’s stock price as neutral based on the below forecast assumption.

Recommended buy price: $82

Fair Price : $90.5

Recommended Sell price: $103

Sales (short-term) : 5.8%

Sales (long-term) : 4.2%

AVG. Gross Margin : 30.5%

AVG. Operating Margin: 10.9%

I urge the potential investors to look at the margin and operating cash flow growth rather than sales for future earnings. I expect those are the critical drivers of Ross’ valuation improvements.



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