Ross Stores Are Compelling After Pullback

Ross Stores' fourth-quarter results were not too exciting. However, investors who bet against the company do so at their own peril. Over the long haul, its growth prospects appear brighter than fellow closeout retailers TJX  and Big Lots .

An investment in Ross may not be stylish right now, but those with a long-term horizon should remember: Fads are short term but solid businesses are built to last.

A concept for the ages
The retailer offers quality merchandise at a discount. Granted, the concept has more appeal when the economy is not faring well, but it should never go out of style.

Its execution has been exemplary. In 2008, the gross margin was 23.6% and reached 28% at year-end 2013. The pre-tax earnings margin rose from 7.6% to 13.1%. Earnings per share grew at least 20% from 2010 through 2012.

The off-price retailer does a nice job of separating into two distinct but easily understood brands. Ross Dress for Less offers name brand and designer apparel, accessories, footwear, and home fashions at 20% to 60% discounts to department and specialty-store prices. This segment targets middle-income households.

Its dd's DISCOUNTS stores offer more moderately priced goods in the same categories. The prices are 20% to 70% off where merchandise is regularly sold at moderate department stores and discount retailers.

A recent hiccup
Growth has slowed from a fast pace over the past few years. Still, comparable- store sales increased a decent 2% in the fourth quarter. Although the year-ago period includes an extra week due to a quirk in the retail calendar, this metric compares equal 13-week periods.

Diluted earnings per share were $1.02, up about 5% from a year ago, excluding the additional week from that period. Management estimates this added $0.10. Granted, buying back stock helped the net share figure since there were about 7.4 million fewer shares. Back in November, management gave cautious guidance for the quarter, citing a competitive pricing environment. It called for a comparable sales increase of 1% to 2% and earnings of $0.97 to $1.01 a share.

Looking ahead to fiscal year 2014, the company estimates a 1% to 2% comparable-store sales increase and earnings of $4.05 to $4.21 a share, about 4% to 9% above last year.

The slowing growth might be disconcerting except other closeout retailers are also having a difficult time. TJX's fourth-quarter comparable-store sales increased 3%. Diluted earnings per share were $0.81, rising 9% after the impact of the prior year's extra week is eliminated. However, like Ross, the net share figure received a boost from repurchased shares, which reduced the count by about 18.5 million shares compared to the year-ago period.

The economy is doing better, by most measures. This means less merchandise to purchase from manufacturers since items are swallowed up by the mainstream retailers. Consumers may not want to wait until the goods reach the closeout retailers.

Nonetheless, offering high-quality merchandise at a discount seems to be a strong strategy over the long run, and Ross has more room to grow than TJX. There are 1,146 Ross Dress for Less stores in 33 states and Washington, D.C. and 130 dd's in just 10 states. Larger rival TJX operates more than 3,200 stores throughout the U.S., Canada, and Europe. It has a presence in all 50 states.

Meanwhile, Big Lots may have bigger problems beyond the economic cycle. For starters, its fourth-quarter comparable-store sales fell 3%. Its earnings per share from U.S. operations, which exclude its Canadian operations and charges to close its ill-fated business, declined 30.3% to $1.45. This year's results are expected to be flat, at best, according to management's guidance of $2.25 to $2.45 per diluted share from U.S. continuing operations. 

Friendly approach to shareholders
While waiting for a cyclical upturn, shareholders will be content to know Ross Stores is using its prodigious cash flow to repurchase shares and increase its dividends. Even with a sluggish fourth quarter, free cash flow was still $471.5 million in 2013. Granted, this is lower than the $555.2 million generated a year ago. But this was because it boosted spending on capital expenditures by $126.1 million, which it hopes will generate cash flow in the future.

Even with this investment, it spent $550 million to repurchase 8.2 million shares. The company expects to spend the same amount this year in order to complete its $1.1 billion repurchase authorization. Ross has also consistently raised its dividends, even through the economic rough patch in 2008 and 2009. Since 2004, dividends have gone from a yearly payout of $0.17 per share to the current $0.80.

Investors should also be encouraged that Ross is not borrowing heavily to repurchase shares and pay dividends. Total debt remains at $150 million, or just 7.5% compared to its book equity of more than $2 billion. Furthermore, the company has $435.2 million in cash and short-term investments.

Final Foolish thoughts
Shares of Ross Stores are trading at about 18 times earnings, making them hard to classify as cheap. However, the stock has become more attractive with the recent sell-off in November, when it was trading at 21 times earnings.

The current valuation is also not grossly expensive, and investors will get shares in a solid company with a great balance sheet. While we may not know when the next economic downturn will come, we know it is inevitable. Collecting reliable and increasing dividends seems to be a good strategy while waiting for the company to shine when the economy hits its next rough patch.

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Lawrence Rothman has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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