Value For Customers And For Investors

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It's no secret that discount retail is a tough business. When you add in the additional challenge of discounting clothing and goods that other stores didn't want, or couldn't sell, it takes talent to make this type of business work. However, companies that get the formula right can make a lot of money. One large company that has been successful is The TJX Companies (NYSE: TJX). While Marshalls and TJ Maxx are attractive stores, there is a smaller company in this game that offers more promise. Ross Stores (NASDAQ: ROST) is the name, and discount retail is their game.

How Do You Sell What Someone Else Couldn't?
Ross' business model is very simple, the company buys merchandise from other retailers and from designers directly. The key is to buy attractive merchandise, and keep the selection fresh. The company buys merchandise at a massive discount to the retail price, and then sells it for "up to 60% off department store prices”. Ross describes its stores as “no frills” and that's being kind. What you get at Ross is racks and racks of deeply discounted clothes. In this environment, customers don't care what the store looks like, what they are paying attention to is the price tag. 

So if this sounds like The TJX Companies stores, why not just buy their stock? The difference is, Ross has less than half the stores, and has a faster growth trajectory. The TJX Companies has 984 T.J. Maxx stores and 884 Marshalls. Given there are roughly 1,000 Ross Stores, it's not hard to imagine the company doubling in size.

Just How Good Are Their Results And What About The Big Guys?
It's not as though Ross and The TJX Companies have this niche all to themselves. In fact, both Target (NYSE: TGT) and Wal-Mart (NYSE: WMT) have been pushing to expand and improve their clothing selection. While many customers visit Wal-Mart or Target on a weekly basis to do their grocery shopping, Ross has to rely on clothing and housewares to get shoppers in the door. 

If there is any question that shoppers are willing to make the trip to Ross, let's look at the numbers. In their last earnings report, Ross indicated that sales were up 11%, and same-store sales were up 6%. The company also increased its store count by 7% on a year-over-year basis, and grew EPS by 14%. If you dig into the company's financials even further, you can see that Ross is outperforming their competition in at least two areas.

It's All About The Cash
Since earnings can be manipulated with one-time items, I like to compare how well companies generate free cash flow. In order to even the playing field, I look at free cash flow per dollar of sales. Using this measure, Ross is more effective generating free cash flow than either The TJX Companies, Target, or Wal-Mart. In the current quarter, Ross generated $0.045 of free cash flow per dollar of sales. The TJX Companies produced $0.04, whereas Target and Wal-Mart generated $0.03 and $0.02 respectively. What is even more impressive is, Ross was able to generate this type of free cash flow with a lower gross margin than the majority of their competition. 

Wal-Mart reports the lowest gross margin of the group at 24.94%, and this is tied to the fact that the company competes so heavily in the grocery business. The TJX Companies and Target cater more to the fashion and home furnishing crowd, and it shows in their gross margins of 28.78% and 31.67% respectively. The fact that Ross carries a gross margin of 27.12% and yet generated more free cash flow per dollar of sales is testament to management's focus on expense controls.

What isn't a surprise is Ross' better free cash flow leads to a lower free cash flow payout ratio as well. In fact, in the last earnings report, Ross showed a free cash flow payout ratio of 30.55%. By comparison, The TJX Companies ratio was 33.74%, Target's ratio was 53.03%, and Wal-Mart came in at 57.46%. While it's true that all of these companies pay a higher yield than Ross, this lower payout ratio means the company should be able to increase their dividend in the future without investors worrying about its sustainability.

Dress Up Your Portfolio
If you look at the relative value Ross offers, it's hard to make an argument against buying the shares. Analysts are calling for 13.17% EPS growth in the next few years, the stock yields about 1%, and shares trade for just over 15 times projected earnings. The TJX Companies is expected to grow slower, has a higher P/E ratio, and about the same yield. When it comes to Target and Wal-Mart, Target is easily the better value with a better growth rate and better yield, for about the same forward P/E ratio. This leaves the choice between Ross and Target. The fact that Ross generates 73% more relative free cash flow per dollar of sales, and has a dividend payout ratio that is 42% less, helps clear up the choice. Ross is where customers are encouraged to dress for less, and investors looking to dress up their returns should add ROST to their Watchlist today.

MHenage 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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