Urbem's 'Wonderful Business' Series: Ross Stores

A winning business model taking advantage of retail and macroeconomic headwinds Continue reading... Read More...

California-based Ross Stores (ROST) operates the off-price retail business through its 1,550 Ross Dress for Less stores (America’s largest off-price apparel and home fashion chain) in 39 states and 260 dd’s DISCOUNTS stores (targeting a more value-focused segment) in 19 states. In terms of fiscal 2018 sales, top categories included Home Accents, Bed and Bath (26%), Ladies (26%), Men’s (14%) and Shoes (13%).

As you might have imagined from the breakdown above, female shoppers represent the majority of the customers, making up 70-75% of the total number of shoppers. They shop for themselves as well as other family members. Thanks to superior brand loyalty, core customers average about two to three store visits per month.

Bargain shoppers often spend time on “treasure hunting,” the discovery-based experience of which is challenging to imitate online. Besides, in-store jumble, increasingly dubious merchandizing, the handy “Compare to” feature and value-oriented SKUs are difficult for online retailers to completely replicate.

In the U.S., we see that Ross Stores dominates the off-price space, alongside the TJX Companies (TJX). These two companies both consistently delivered high returns on capital over the years compared to their peers, Burlington Stores (BURL) and Tuesday Morning (TUES) (see below).

Compared to TJX Companies, we appreciate the laser focus at Ross Stores on the U.S. market and the brick-and-mortar model. In our opinion, both companies possess a substantial moat derived from their leading brands and scale/efficiency advantage in the retail space, and hence will most likely maintain a high return on capital for the foreseeable future.

As U.S. consumers continue to seek out bargains, off-pricers bulletproof themselves by offering terrific brands at significant savings every day. The retail niche has a proven track record of consistent growth, even in challenging industry and macro-economic environments. According to the chart below, both Ross Stores and TJX Companies managed to grow their sales throughout each of the past three recessions.

At Urbem, we particularly favor asset-light operations. Ross Stores needs very minimal capital to sustain its operations. Without opening new stores, annual CapEx usually totals less than $300 million to mainly cover the maintenance of existing stores, distribution, transportation and IT systems – that is only 2% of fiscal 2018 revenue.

The total brick-and-mortar space has been facing significant disruptions from e-tailers such as Amazon (AMZN). However, Ross Stores turns this headwind into a tailwind as it keeps capturing market shares and inventory opportunities from retailers closing stores or going out of business.

In addition to the favorable structural shift, the company can continue to grow profitably by expanding its store footprint in light of the stable same-store-sales growth over the years. The management estimates a U.S. market potential of 2,400 locations for Ross Dress for Less and 600 for dd’s DISCOUNTS. Some regions, such as the Midwest, await further penetration. However, compared with the current store numbers, we feel a bit less confident about the long-term growth prospect of the company’s flagship Ross Dress for Less, which is already the largest chain in the country. In this regard, as more stores are added, same-store-sales needs to be closely monitored.

Some other risks, in our view, include an insignificant insider ownership (i.e., around 2% of total share outstanding), an increasingly crowded industry with Macy’s (M) Backstage and Nordstrom’s (JWN) Rack entering this lucrative niche and a more sophisticated tech-driven supply chain management that could reduce the sourcing opportunities for off-pricers. Moreover, the management at Ross Stores has been heavily relying on share buyback to return capital to owners. This approach should work to create shareholder value if the stock is attractively priced, while we observe that the valuation of Ross Stores has been trending up for almost a decade now (see below).

Disclosure: The mention of any stock in this article does not constitute an investment recommendation; investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market; we own shares of Ross Stores.