Ross Stock: Off-Price Buying Strategies Imply High Valuation (NASDAQ:ROST) (2024)

If Ross Stores, Inc. (NASDAQ:ROST) continues to execute its off-price buying strategies and the marketing efforts are successful, future FCF implies a valuation of $147. That’s not all. With labor-saving technologies included in the company’s store design and correct real estate management, I believe that $220 per share is also fair. I also identified several risks in ROST’s business model. However, with the current share price of $101-$107, I couldn’t resist buying some equity.

Ross Stores Plans To Open New Stores To Offer Quality Brands At Great Discount

Headquartered in Dublin, California, Ross Stores runs two brands of off-price retail apparel and a home fashion store.

The company’s business model is based on offering bargains and a constant flow of fresh merchandise so that clients never get bored. The business model has successfully operated since 1982.

Source: IR

The merchandise mix appears to be well-diversified. Women, children, ladies, and men find clothes. Customers can also buy accessories, fragrances, jewelry, and much more. In my view, product diversification will make the company’s revenue line less volatile:

Source: IR

The management intends to invest in its employees and continue to offer quality. It is focused on capturing market share from other retailers that close their stores or go out of business. With these goals, the management has been very successful in the past. I don’t understand why it wouldn’t be different in the near future:

Source: IR

Balance Sheet

The company’s financial situation appears solid. Since August 2020, the total amount of cash has increased from $3.7 billion to more than $5.56 billion. I would expect significant revenue growth when the company uses its cash to open new stores as well as to launch communication campaigns:

Source: 10-Q

With close to $2.45 million in long-term debt, I wouldn’t worry about the company’s financial obligations. At the end of the day, the company’s net debt is negative:

Source: 10-Q

I also checked the company’s contractual obligations. In total, Ross Stores disclosed $13 billion in contractual obligations including purchase obligations worth $5.52 billion. If we assume a free cash flow of $2 billion, the total amount of contractual obligations is equal to 6x-7x, which does not look worrying:

Source: 10-Q

If The Company’s Marketing Efforts And Off-price Buying Strategies Continue To Be Successful, Ross Stores Is Worth $147

Like other analysts out there, I am quite optimistic about the future performance of Ross Stores, Inc. We all cannot be wrong. The figures below offer information on the expectations of other analysts. Expectations include sales growth and growing FCF with FCF/Sales of 14%-8% from 2021 to 2024. Take a look at the figures below, so that you come to know that my numbers are not far from that of market estimates:

Source: Market Screener

In my view, if the company maintains an appropriate level of recognizable brands, strong discounts, and a lot of communication expenses, sales growth will continue. Besides, the management will most likely meet clients’ needs on a local basis. My assumption is that the management understands very well how to offer an in-store shopping experience, and will successfully continue to do so.

In my opinion, Ross is a leader because the management executes off-price buying strategies that enable the company to offer merchandise at strong discounts. In the most recent annual report, the company provided some information about the buying process. In my opinion, the know-how accumulated will most likely permit the management to deliver significant free cash flow growth:

By purchasing later in the merchandise buying cycle than department, specialty, and discount stores, we are able to take advantage of imbalances between retailers’ demand for products and manufacturers’ supply of those products. Source: 10-k

With these assumptions in mind, let’s now review my financial model. I expect sales growth of 46%-2% and EBITDA margin of 9%-17% from 2022 to 2026. I expect D&A to increase from $351 million in 2020 to $528 million in 2026. I also expect that Ross will be able to reduce its accounts payable from $960 million in 2021 to $49 million in 2026. Putting everything together, I expect unlevered free cash flow to grow from $1.49 billion in 2020 to $2.2 billion in 2026. Notice that the company’s FCF/Sales would stand at close to 9.9%, which, in my view, is quite conservative:

Source: Author

The CAPM model includes a beta of 1.08-1.24, cost of equity of 7.5%-8.5%, and cost of debt after tax of 2.9%-3.3%. For most market participants, I believe that the WACC would stand at 6%-8%. In this case scenario, I used a WACC of 6%:

Source: Author and finbox

In sum, I obtained a sum of free cash flow of $10.4 billion. Besides, using a 2027 FCF multiple of 17x and a terminal FCF of $2.2 billion, the net present value of the terminal value is close to $38 billion. Finally, with 355 million shares outstanding, the implied share price is equal to $147. With ROST currently trading at $101-$107, I believe that the company is a buy.

Source: Author

With Successful Real Estate Management, Labor Cost Management, And Economies of Scale, The Company Is Worth $220

The management of the company’s real estate growth is very important. The company makes significant investments in property management, equipment, and leasehold improvement. Notice that only lands and buildings represent close to $1.1 billion standing in the balance sheet. Ross Stores also expects to open 65 new stores in fiscal year 2021, and may open close to 100 stores per year from 2022.

I expect that the management will be able to open stores in new markets, and will adapt its offering to the specific local demographic characteristics. At the same time, I will be expecting closure of stores that are not performing.

Source: 10-Q

In the annual report, the company has laid special emphasis to the fact that its store design creates a self-service retail format. As a result, the management expects labor-saving technologies, which, in my view, will enhance FCF margin in the next five to ten years. I also believe that the management will most likely benefit from economies of scale resulting from centralized merchandising.

If the company achieves all the previous goals, I expect sales growth close to 45%-10%, an EBITDA margin of approximately 20%, and FCF/Sales around 10%. As shown in the table below, UFCF would grow from $1.495 billion in 2020 to close to $3.280 billion in 2025:

Source: Author

In this case scenario, my expectations are quite optimistic. If the company delivers the expected sales growth, the demand for the stock would increase. As a result, I would expect a significant reduction in the cost of equity and a decrease in the WACC. With this in mind, notice that I used a WACC of 5.75% and exit multiple of 17.5x 2027 FCF, which imply a share price of $220:

Source: Author

Risks From Any Event That May Damage The Company’s Reputation

Ross Stores sells merchandise because clients trust the company’s integrity, and they respect the company’s brand. Investors will most likely understand that the company’s reputation could be damaged by any incident with suppliers, landlords of the stores, or protests not related to the company’s business. In that case scenario, the company may report less revenue, and the free cash flow may decline. As a result, the expectations for FCF could diminish, which would lead to a significant decrease in the company’s valuation.

Risks From Changes In Customer Trends And Preferences

The management continuously tries to identify customer trends and preferences. The company obtains merchandise inventory in advance and needs to understand new customer needs very well. It is a challenging process that can be completely wrong. If the company cannot adjust its merchandise mix to the changing consumer tastes, revenue could grow less than expected. In this case scenario, consumers may visit fewer stores, and the free cash may decline. The final result of this process will be a dramatic decline in the valuation of Ross Stores, Inc.

Conclusion

Under the assumption that the company’s off-price buying strategies will be successful and the marketing efforts will bring revenue, I obtained a target price of $147. That’s not all. If the company manages its real estate assets effectively, and labor-saving technologies bring a reduction in the FCF margin, my target price is $220. There are some risks. However, with the current share price of $101-$107, the company really looks like a buy.

I am an financial advisor living in Europe. I conduct due diligence for clients across multiple sectors. I hold more than 15 years of expertise.I only write about my opinion. Investing in securities involves risk of loss that readers should be prepared to bear. No investment process is free of risk; no strategy or risk management technique can guarantee returns or eliminate risk in any market environment.