Ross Stores: Old School vs. New School Retail

February 5, 2016 |

The bear argument against Ross Stores (ROST)—the off-price apparel and home fashion retailer—in the near term is strong but I think the bull case for Ross is stronger. The bear case goes, Ross—unlike other apparel stores—does not have an online store, it has no international markets, and its operating costs will increase because 25% of its stores are in California where the minimum wage is rising. Yet those are the same reasons for a bull case if we take into consideration Ross’s target consumer, the rung of the apparel ladder Ross is on, and where the market opportunities are.

I hope to show that in the current environment of aggressive promotions, increasing competition, and a rising savings rate, an old school brick-and-mortar retail has some key advantages over new school online retail. Even though online shopping is the future, it is requires significant economies of scale to be profitable. Consequently, I think Ross is on the right track with its decision to first focus on expanding the old school way, by adding brick-and-mortar stores, and then use the resulting increased scale of operations to easily break into the new school online stores.

The Bear Case

Apparel Industry is Getting Tougher

The apparel industry is getting tougher due to increasing competition, growing promotions and an increasing personal savings rate. These headwinds will combine to drive down margins in the apparel industry. This is true to an extent.

Ross is facing rising competition from a number of sources, primarily department stores who are seeing their margins fall because of warmer weather and lower spending from consumers (locals and tourists). Falling margins push department stores to discount their products to appeal to value conscious clients. For instance, Macy’s sales in places like New York, Chicago, and San Francisco have been declining because of warmer conditions and lower consumer spending. In response, Macy’s in May and June, 2015 piloted its own off-price business (off-price basically means that goods are sold at considerably lower prices than those typically charged by retailers), Macy’s Backstage, in six stores in New York. Such competition will adversely impact the growth of Ross’s margins because both compete directly for clients in Washington DC, Illinois, Nevada, Pennsylvania, New Jersey and California.

Although Real Personal Consumption Expenditures (PCE)—a primary driver for consumer spending—grew 3.1% in 2015, the personal saving rate grew even faster at 5.2%, according to the Bureau of Economic Analysis. This was also the trend in 2014; Real PCE grew 2.7% compared to the savings rate which grew 4.8%. This means that consumers are increasingly saving more, which translates into less revenue for apparel stores like Ross.

Higher Minimum Wages are Coming

Ross is has about a quarter of its stores in California (as shown below) and California is facing rising minimum wage increases. The raise from $9 to $10 an hour just took effect on January 1 this year. Rising wages will increase Ross’s operating costs and reduce margins because the majority of Ross’s employees make minimum wage.
ross locations

Compared to Texas and Florida, the other states where Ross has a significant number of stores, California has one of the highest minimum wages in the nation. For instance, its $10 per hour is $2.25 higher than that of Texas and $1.95 higher than that of Florida according the Department of Labor. Additionally, there arecampaigns to raise it to $15 by 2020 and 2021. The following table, from the Department of Industrial Relations, shows California’s history of minimum wage hikes since 1998.
california minimum wage history

Lack of an Online Store

Ross does not have an online store and therefore it will lose market share to competitors that have an online presence. E-commerce offers the apparel consumer bargains without the need to go to the store thus they save both time and money. Additionally, Ross management has acknowledged that its client base is tilted towards young buyers. Bears argue that young buyers tend to be more tech savvy and thus more likely to shop online.

No International Markets

Unlike its peers, Ross does not have any international exposure. Bears argue that some of its competitors like TJ Maxx (TJX) are experiencing their fastest growth in international markets. Thus Ross is missing out on additional revenue and by choosing to only expand in the US, it is losing out on higher growth.

Bear Upshot

All these reasons point to the bearish conclusion that Ross has very little upside potential and significant downside risk in near term.

The Bull Case

All the aforementioned bear reasons actually point to significant upside potential when we take into consideration who Ross’s target client is (middle to low income households), where on the apparel ladder Ross is (they are a low gross margin retailer which puts them at the bottom), and where the market opportunities for expansion are.

Apparel is Outperforming

The following chart shows that the apparel industry (in blue), although losing some of its gains, is still outperforming consumer cyclicals (in green) and the S&P 500 (in red, set as a baseline):
apparel industry

It is true that the savings rate has increased, that competition is rising and that promotions are plenty and that all of these factors work to reduce margins for apparel retailers. But Ross’s business model is designed for low margins due to the big discounts it gives its customers, usually in the range of 20% to 60%. Additionally, Ross’s dd’s Discounts stores cater to “households with more moderate incomes” than middle income households by offering even greater discounts, up to 70% off price. Falling margins in the industry will affect all apparel retailers, but more so those retailers at the higher rung of the ladder (retailers with high gross margins like Macy’s, JC Penny etc.) than those at the bottom (retailers with loss gross margins such as Ross and TJX). As margins get smaller, discount retailers like Ross, which have very efficient operations, perform better because they are already used to taking smaller margins and squeezing profit out them. The following table shows Ross’s operational efficiency:
ross profitability

The retailers with the lowest gross margins (i.e. at the bottom of the apparel ladder like ROST and TJX) but have the highest operating margins, highest EBITDA margins, and highest net margins. It is worth noting that Ross tops its peers on all of those margins. As thriftier consumers hunt for bargains, and as competing retailers mark down their prices, off-price retailers like Ross will do well because they are already known for their large discounts and have mastered the formula.

The Other Side of Increasing Minimum Wages

It is true that increasing minimum wages will drive Ross’s operating costs higher, but that is only one side of the story. The other side of the minimum wage story is that Ross’s target customers—many of whom are themselves making minimum wage—have more disposable income. In other words, increasing minimum wages also mean more money flowing into middle to low income households. If the Federal Reserve Bank of Chicago’s and Congressional Budget Office’s findings are anything to go by, then we can say that rising incomes lead to increased demand for goods and services.
california retail trade compensation

The graph above plots total compensation in retail in California over time. It is apparent that compensation has been increasing since 2010 Q2 but so has total personal consumption expenditure on clothing and footwear as shown in the graph below. While it is tough to conclude that rising compensation led to more spending, we can say that it is associated with increased apparel and footwear outlays.
california clothing and footwear compensation

So even though rising minimum wages will reduce Ross’s operating margins, I expect that those reductions will largely be offset by increases in consumer spending on apparel. On top of rising wages, declining energy prices have put more money in the pockets of Ross’s target consumers.

Not Having Online Store is Good in the Near Term

Not having an online store is actually good for Ross because it helps keep operating margins high. Ross operates at bottom of the apparel ladder, so keeping costs low is critical to maintaining profitability. Although online shopping (new school) is the future of retail, it remains an economy-of-scale business. Without a large scale of operations, it is hard to make money especially when you discount your merchandise as much as Ross does. But even with large economies of scale, making money from e-commerce is still challenging because of the high cost of shipping. For instance, Amazon still runs losses on its online business as shown below (Source: Company Filings):
amazon store

Ross’s competitor, TJX noted that e-commerce “had an immaterial impact on fiscal 2015 net sales growth” in its recent annual report. Additionally, Target’s online sales only account for 2.7% of sales according to their most recent quarterly report. Most of Target’s and TJX’s sales came from the old school brick-and-mortar stores, not the new school online stores, and in the near term this will continue to be the case.

For investors, the major worry that arises from Ross not being online is that Ross will lose market share by being a late entrant into the online space. But I think it’s better to be late and prepared, rather than early and unprepared.

Online stores are capital-intensive while the off-price business is margin-sensitive, so an off-price retailer like Ross needs be careful about going online. Online stores, unlike the old school brick-and-mortar , serve wider areas than small local communities. They need distribution centers, payments systems, shipping logistics etc. to function, thus requiring the retailer to have a large national footprint to be viable. Although Ross is in 36 states and territories, it doesn’t have enough brick-and-mortar stores/distribution centers to make an online store feasible. Therefore, Ross’s s strategy of focusing on brick-and-mortar store expansion is the right one to pursue. When it has a sizeable national presence and a bigger pile of retained earnings, it can go new school.

The Grass isn’t Greener Abroad

It is true that international ventures can be highly profitable if well executed, but it doesn’t make sense for Ross to go abroad when there are markets in the US it has yet to exploit. Simply put, the market opportunities are not abroad, they are right here in the US. It is expensive to establish and develop operations in international markets—as evidenced by Target. Its foray into the Canadian market has cost the company in excess of $5 billion and it would have taken the Canadian segment until 2021 to be profitable, according to management. It has pulled out of Canada and decided to focus on markets in the US. Expecting Ross to venture into international markets is essentially advocating for Ross to adopt the rapid growth strategy that got Target in trouble.

Moreover, even though international markets are lucrative, they present additional risk because of currency fluctuations. For example, TJX net sales from TJX Canada were basically flat in 2015. TJX reported in its most recent 10K that:

“Net sales for TJX Canada in fiscal 2015 were essentially flat compared to fiscal 2014. While net sales reflected a 4% increase from new stores and a 3% increase from same store sales, these were offset by currency translation that negatively impacted sales growth by 7%.”

The previous year, currency translation reduced TJX Canada’s sales growth by 2%. However, I should note that currency risk can also be favorable because it boosted TJX Europe’s sales in 2015 by 2%. The crux of it is that the retailer’s growth in international markets needs to be high so that it can offset currency headwinds and recover the large initial capital investments. Unfortunately, that is not always guaranteed and striving for high growth sets up the trap that Target fell into in Canada—taking on too much too fast. For Ross, slow and steady (3% comps) at home will do the trick; international markets can come much later. Target only realized this with $5 billion in the hole; it would be unfortunate if Ross didn’t learn from Target.

Analyst Estimates Are Being Revised Up

Here’s a little something extra to add to my case: analyst estimates for Ross’s earnings next year are being revised up (modestly), while those of its peers are being downgraded. Ross’s earnings for 2017 have been revised up from $2.71 ninety days ago to $2.75 seven days ago as shown below:
ross eps trends

In contrast, those of its competitors are being revised down. For instance, TJX’s were revised down from $3.71 ninety days ago to $3.60 seven days ago:
tjx eps trends

Obviously, analyst estimates are not a perfect barometer for predicting how a company will perform in the future, but upward revisions are never a bad thing, and downward revisions often portend further downward revisions. So I take this as a positive sign for Ross, and a negative sign for TJX.

A Note on Valuation

Ross is by no means cheap, but that also goes for fellow off-price retailer TJX. The market recognizes the upside potential these two have and that is why they are trading at a premium as shown below:
ross valuation

Ross could have a significant drop in the price if there are higher-than-anticipated costs in opening new stores. Nevertheless, I think Ross still has upside potential as it will continue to grow EPS at between 10% to 12% like it has done in the past (EPS 1-Year Change = 10.9% and EPS 3-Year Change = 11.4%) compared to TJX which is has been growing EPS between 4% and 9% (EPS 1-Year Change = 4% and EPS 3-Year Change = 8.7%). This is because Ross’s s EPS growth guidance for 2015 is between 11% to 12% and as shown analyst revisions for 2016 and 2017 have been going up. As a result, I expect to see a bigger differentiation going forward in valuation between Ross and TJX as the market begins to place a higher premium on Ross. Ultimately, I think Ross is a long term growth play.

Conclusion: Old School is Still Cool

Fundamentally, the bull case for Ross is stronger than the bear case. The bull case is predicated on management continuing its current strategy of expanding the number of brick-and-mortar stores into new markets within the US, as opposed to starting an online store or going abroad. That strategy will ensure that Ross not only retains and improves its operational efficiency, but also grows its national footprint. When it has the large distribution centers, proper delivery logistics, robust payment systems, efficient inventory process, and enough retained earnings, it can easily transition to the new school. For now, Ross should keep it old school: continue giving customers attractive discounts and investors handsome returns.

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