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MagicDiligence (< 20)

Earn a 20% Return With Low Risk by Investing in this Well-Run Retailer



February 19, 2014 – Comments (0) | RELATED TICKERS: ROST , TJX , WMT

Ross Stores (ROST) is an attractive stock currently showing up in the Magic Formula® Investing screens. I believe the stock could generate a 20% one-year return for investors at its current valuation, and with relatively low risk.

Not only that, you would be investing in one of the best run and most successful retail chains in America.

Let's take a look at this compelling investment opportunity...

What Ross Stores Is

Ross Stores operates almost 1,300 retail stores in the U.S. under the Ross Dress for Less (about 1,150 locations) and dd's DISCOUNTS (130) names. Both are large, department-store sized concepts that focus on off-price apparel and home fashion, selling designer brands in clothing, accessories, and footwear for 20-60% off department store prices. Ross Dress for Less is targeted at middle-income households, while dd's DISCOUNTS aims for lower-income customers.

Ross acquires its merchandise by purchasing cancellations and overruns, utilizing a strategy of buying at the end of season and warehousing for sale the next year. Foregoing manufacturer promotion allowances and return privileges, and keeping staffing to a minimum allow the company to stock quality product at truly discount prices.

Growing, Profitable, and Well-Run

Ross has grown revenues at a 5-year compound annual growth rate (CAGR) of close to 10%. Management believes the U.S. can support a doubling of the current store count, which seems reasonable considering Walmart (WMT) has almost 3,300 U.S. locations. In fact, the company is currently only in 33 states! Ross has been increasing store count by about 5-7% annually, and tacking on 1-3% same store sales growth, I think Ross can grow revenues at 6-10% per year for many years.

This is also an extremely well run company. Management is long-tenured; CEO Michael Balmuth has been at the helm since way back in 1996, spearheading the firm's impressive performance over the past 15+ years. Recently, operating margin has ticked up from 7.6% in 2009 to almost 13.5% presently, owing to continuously improving sourcing, operational efficiency, and the flock of consumers to lower-priced retailers. Ross's 5-year average return on capital stands at 64%, which is remarkable figure for ANY company!

We might as well also touch on financial health - it's excellent. Consider:

Ross has almost $400 million in balance sheet cash, dwarfing its $150 million in total debt.Free cash flow has consistently checked in at 7-10% of revenues and has been remarkably stable over the years.Ross instituted a dividend in 1997 and has raised it EVERY year since. The payout ratio is under 18%, so more dividend hikes are almost guaranteed.The company has been a prolific repurchaser of shares, reducing its share count by 3-5% every year for the last decade.

You can look at a lot of companies before finding one with a track record even close to that of ROST. This is a truly fantastic company.

The Opportunity to Buy is Now

Ross is down almost 16% over the past 3 months, setting up a rare buying opportunity for investors. Fiscal (Jan.) 2014 results will come in lower than analysts had hoped, but the company should still generate 6% revenue and 9% pre-tax profit growth - not bad compared to most retail last year.

Currently, Ross' valuation is at the low end of its historical range. Its EV/EBIT earnings yield currently stands at 9.5%, well above the 5-year average of 6.7%. Main competitor TJX Companies (TJX) has a current earnings yield of 8.0%, so there is significant relative value here. Additionally, a discounted free cash flow calculation, assuming 6-10% growth and a 10.5% discount rate, nets me a target price around $80/share. That's over 18% of upside from current prices under $69.

Ross Stores is a fantastic company at a more-than-fair price, and represents one of the more attractive Magic Formula stocks at present. We will keep it in close consideration for addition to our Top Buys portfolio.


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