Don't Give up on Ross Stores and TJX Companies Just Yet

t's been a difficult couple of quarters for off-price retailers like TJX  and Ross Stores with a combination of extreme bad weather and a tough retail environment causing sluggish sales growth. The question going forward is whether this is just a temporary, weather-related phenomenon or the start of a downtrend.

TJX and Ross Stores report
Ross Stores and TJX have both reported and given disappointing sales growth figures. A chart of their comparable same-store sales figures (adjusted to fit the calendar year) demonstrates that they tend to follow each other and that the last two quarters have been difficult.

Source: TJX Companies and Ross Stores Presentation

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Ross Stores Looking Good For 2014

After a strong share price move leading into its earnings, off-price retailer Ross Stores  disappointed investors with its quarterly results and guidance. Meanwhile, its main rival TJX cheered the market by beating estimates and raising guidance. It's time to look at Ross Stores and assess whether or not the recent decline is a buying opportunity.  In addition, looking at trends in discretionary spending at Dollar Tree, Dollar General  , and Family Dollar  will help guide Foolish investors towards a clearer picture of conditions at the lower end of retail.

Ross Stores breaks a trend
Some stocks can develop a logic all of their own. The market has gotten used to TJX and Ross beating their respective internal guidance. Subsequently, when they fail to do so it's regarded as a disappointment. While TJX managed to generate 5% same-store sales growth (its guidance was for 2%-3%) in the quarter, Ross's same-store sales came in lower than the mid-point of its guidance for the first time in a long while. Moreover, Ross' fourth-quarter guidance of 1%-2% same-store sales growth was uninspiring.

Source: company presentations

It gets worse. In discussing the business environment on the conference call, Ross' management noted a number of reasons why the company was taking a more cautious approach to the rest of the year.

retailers are planning to open earlier than prior years on Thanksgiving Day... ...6 fewer shopping days in 2013 between Thanksgiving and Christmas... ...retailers have reported disappointing results over the past few quarters... ...will create the most intensely competitive and promotional holiday selling period in recent years.

Moreover, Ross' traffic was flat in the quarter, with an increase in basket size driving sales growth. This could be a concern, because in a shorter selling season, traffic is going to be even more important than usual.

Frankly, Foolish investors should look out for more variability in the outlook statements from the retail sector this Christmas. Companies can only report what they are seeing, and spending trends are likely to change dramatically because of the shortened selling season. 

While Ross is gloomy, what is the rest of the industry saying?

What Dollar General, Dollar Tree, and Family Dollar said
TJX raised its guidance, but it was noticeable that it did not adjust the guidance for its fourth quarter, which indicates some caution. Turning to the dollar stores, they have been battling all year to try to increase their discretionary-product sales. Such products tend to come with higher margins than consumables, and they are a good indication of a return to spending power at the lower end of the market.

Dollar Tree's relative performance with discretionary products has been better than the other dollar stores this year. Indeed, on its third-quarter conference call management stated "So what you saw beginning in Q2 this year was a little bit of a shift, with the non-consumables growing a bit faster than the consumables." However, it's not entirely clear whether this is a macro effect or a response to Dollar Tree rolling out relatively fewer consumable products than it has in previous years.

The picture wasn't any clearer with Dollar General in its third quarter. In response to an analyst's question on "encouraging" discretionary trends, CEO Richard Dreiling replied that he thought the "trade-down customer is getting more comfortable with the quality of the products we're putting out there" and "I think we're doing a much better job on the merchandising selection here." Finally, on its fourth-quarter conference call, Family Dollar argued that there was...

...stabilization in our discretionary businesses and we delivered our best comp performance of the year in these higher-margin categories. We remain cautious on the outlook for our customer, but we do believe that we are turning the corner in several key discretionary businesses.

All three are cautious on the consumer, but frankly, none of them reported deterioration with their discretionary products. It's fair to summarize their statements as mildly positive.

Time to buy Ross Stores?
With that said, is it time to buy into the weakness in Ross Stores with the anticipation that it will beat its cautious guidance?

The dollar stores aren't saying overtly negative things on discretionary spending, and Ross Stores's third-quarter numbers weren't that bad. Its guidance isn't great, but 1%-2% same-store sales growth is what it projected for three of the last four quarters.

Furthermore, on the evidence of the trailing figures collated below, there is a good case for buying in. Note that adjusted free-cash flow is simply trailing operating cash flow minus depreciation. This is a more useful measure of underlying cash-flow generation because all of these companies are in an expansionary phase.

($ in millions)	Dollar Tree	Family Dollar	Dollar Tree	TJX	Ross Stores
Enterprise Value	12,060	7,890	21,600	44,670	15,810
Revenue	7,850	10,391	17,217	27,338	10,114
Operating Cash Flow	731	472	1,242	2,599	1108
Depreciation	187	224	320	544	197
Adjusted Free-Cash Flow	544	248	922	2,055	911
Adj FCF as % Revenue	6.9	2.4	5.4	7.5	9.0
Adj FCF as % Enterprise Value	4.5	3.1	4.3	4.6	5.8
EPS Growth Rate %	10.7	10.2	15.7	13.6	12.3

Source: company presentations, author's analysis

A company that generates 5.8% of its enterprise value (market cap plus debt) in free-cash flow with double-digit growth prospects is usually attractive. Provided that Ross can at least hit its holiday-season guidance, the stock looks like a good value.

TJX Remains a Buy

Investors in off-price retailer The TJX Companies  will be very pleased with the company's latest results. Not only were earnings ahead of estimates, but management also guided investors toward some significant developments that should drive the company's long-term growth. There has always been a lot to like about TJX, and now there is even more.

TJX beats estimates, again
TJX previously guided toward diluted earnings per share in the range of $0.69-$0.72 and comparable-store-sales growth of 2% to 3%, but it delivered $0.75 and 5%, respectively, in its third quarter.

The company has a history of giving conservative guidance, and it arguably did so again this time around. Despite the impressive third-quarter numbers, management reiterated its fourth-quarter forecast of only 1%-2% comparable-store-sales growth, and diluted EPS of $0.77-$0.80. Don't be surprised if it beats projections.

A note of cautionA note of caution came from the outlook provided by a rival off-price retailer Ross Stores. In giving its outlook for the all-important fourth quarter, Ross' management argued that the upcoming holiday season "will be the most intensely competitive and promotional holiday selling period in recent years."

One issue that faces the entire retail industry is the six fewer shopping days between Thanksgiving and Christmas this year. In other words, in-store shopping is likely to be more intense, and retailers will fight hard for foot traffic by offering promotions. This is likely to create some confusing signals from the sector.

However, to be fair, Ross and TJX offered up the same guidance of 1%-2% comparable-store growth in the fourth quarter. The difference was that TJX beat EPS estimates in the third quarter, while Ross was only inline.

It was a similar story with Dollar Tree Stores. The dollar store missed analyst estimates for the second straight quarter, and its management spoke of "weak consumer confidence" and inevitably the short shopping season this year. Furthermore, EPS guidance for the fourth quarter of $1.01-$1.07 was weaker than the analyst consensus of $1.10.

However, Foolish investors should note that Dollar Tree's non-consumable categories (which tend to be more discretionary items) grew at a similar rate to consumable; that's a good sign that consumers do have a bit more discretionary income. It could be that Dollar Tree's management is just being cautious.

TJX's long-term growth prospects
Turning back to TJX, each of its divisions achieved good sales growth in the quarter.

Note that TJX's home goods (10% of total segment profits year-to-date) sales grew much faster than the company average, while according to management Ross' home business "ran at the same rate as the company" in the third quarter. Furthermore, TJX gave some positive updates on its long-term growth plans in three ways.

First, the company's management now believes it can increase its number of stores by 60% to 5,100 stores, with Marmaxx's (73% of segment profits and around 1,966 stores  currently) potential raised to 3,000 locations, some 400 more than it previously estimated.

Second, management declared itself "excited" by its e-commerce plans, and more investment will follow in due course.

Finally, its European segmental margins (6% of year-to-date segment profits) grew to 10.4% versus 9.1% last year, and TJX raised its long-term target to "10%-plus." Considering that Marmaxx has margins better than 15%, it's reasonable to expect that TJX can continue to increase European margins in the future.

Where next for TJX?
It's going to be a tricky season for retailers. The spending environment isn't fantastic, and the shortened selling season will cause great potential for retailers to report mixed signals as the holiday season progresses.

Nevertheless, TJX has consistently demonstrated an ability to appeal to off-price shoppers, irrespective of market conditions. Meanwhile, its long-term growth prospects are getting stronger, and investors should focus on these aspects of its potential rather than the short-term noise created by a shorter selling season.

Nordstrom's Long Term Growth Plan

Deciding whether or not to invest in a high-end clothing retailer like Nordstrom   used to be easy. In the past, it boiled down to your view on the environment for higher-income consumer spending. Although that argument is still applicable, it's far from the full picture now. Nordstrom is undergoing some fundamental changes in its business, and Foolish investors need to consider what this company will look like in a few years.

 

Nordstrom adjusts to a changing environmentThe retailer is best known for its full-line stores. However, its investment plans for the next five years involve shifting sales toward its other sales channels. The idea is to move toward the kind of growth trends that seem to have categorized the US consumer since the recession.

 

For example, off-price retailers like TJX Companies   and Ross Stores have been flourishing, while mid-market department stores like J.C. Penney are struggling. In response to these trends, Nordstrom is investing in its off-price concept, known as the Rack. Nordstrom is also imitating clothing companies such as VF Corp   and Coach, which are investing significantly in their online strategies.

 

Unfortunately, Nordstrom is having some teething problems. Its third-quarter results were a disappointment, with its full-line stores delivering a same-store sales decline of 4.2%. Moreover, it lowered its full-year earnings per share guidance to $3.60-$3.70 from a previous estimate of $3.65-$3.80. The question is if Nordstrom's investment plans are making it lose its focus on its core business.

 

Nordstrom's growth plan
Nordstrom's plan involves ramping up capital expenditures to $3.7 billion over the next five years in a way that changes the way it does business.

 

Source: company presentations

 

Key parts of the plan include:

• Expansion of its Rack outlets (20% of total sales) to at least 230 from 127 today

•  Invest in IT infrastructure initiatives in order to expand its e-commerce sales, and increase stock keeping units, or SKUs, in its online offerings

• A combination of investment in Canada and its US flagship stores, such as the store in Manhattan

Nordstrom and the retail environmentIn order to illustrate the importance of the plan, here is a breakout of Nordstrom's same-store sales data. Note that the direct division includes Nordstrom's own online sales (11% of total sales) plus sales from Haute Look (2% of total sales), an off-price online company it bought in 2011. The numerically aware will have calculated that Nordstrom's full-line stores currently contribute 67% of total sales.

 

Source: company presentations

 

Clearly the biggest issue is with Nordstrom's full-line sales. It is true that Nordstrom's anniversary sale took place in the second quarter -- last year it was across the second and third quarters -- so its third quarter numbers were expected to look weak. However, Nordstrom's full-line sales have been weak for four quarters now.

When pushed on the issue in its conference call, management stated

We don't believe it's attributable to any one factor. That said, we know customers respond to freshness and fashion, and we're working to provide that, combined with ongoing efforts to enhance the store environment and overall execution.

This sort of performance and commentary captures the problem facing many retailers in this environment. If you are not a differentiated specialty store, then consumers want discounts to buy from you. On the other hand, if you discount too much then consumers will lower their perception of the value of your higher ticket items.

 

In this scenario a clothing company like VF, which owns Vans, The North Face, and Timberland, can do well because its outdoor action clothing lines are differentiated. It's also growing its online business. VF has a lot of upside potential, particularly if winter is cold this year. VF's main strength is the ability to invest adapt to changing market conditions because it has a diverse set of brands. In addition, its relatively low penetration in emerging markets (particularly with its jeanswear) means it should be able to generate growth through expansion alone.

 

Meanwhile, off-price retailer TJX has been raising guidance throughout 2013, and it continues to benefit from consumers seeking discounted prices. In fact, TJX just beat analyst expectations with its third quarter results, and raised its long-term estimates for its store expansion program.

What's next for Nordstrom?Nordstrom's strategy is to try and retain premium pricing in its full-line stores while growing its off-price business through Rack expansion. Unfortunately, it looks like its core full-price store growth is weakening, even while direct and Rack sales are expanding.

 

In a sense, Nordstrom's management should be commended for aggressively making the changes necessary to navigate its way through changing end markets. However, the expansion plan contains execution risk and will eat into cash flow in future. Cautious investors will want to see a turnaround in Nordstrom's core full-price stores before buying in. 

TJX and Ross Stores are Still the Pick of the Retail Sector

If the markets needed any more proof that off-price retailers are likely to outperform the market, then they surely got it with the latest results from TJX (NYSE: TJX  ) and Ross Stores (NASDAQ: ROST  ) . Both companies beat their internal guidance in terms of sales and earnings, and demonstrated that they have plenty of growth potential in the years ahead. Despite their strong share-price performance over the last year or so, it's not too late to buy into the story.

Still growing

Both companies generated some pretty impressive comparable-same-store sales growth in the second quarter, and it's noticeable how correlated their sales growth has been over the last few years. In addition, note that they are both lapping some strong growth numbers from last year.

source: company accounts

In addition, they both raised same-store sales guidance for the year.

TJX Companies raises guidance

Following better-than-expected same-store sales growth of 4%, TJX raised its full- year comparable-same-store sales estimate to 2%-3% growth from its previous range of 1% to 2%.

In addition, its new EPS-range forecast of $2.74 to $2.80 represents adjusted underlying growth of 11% to 13% over last year. Furthermore, the commentary around the results suggests that it is achieving its objectives for 2013. There are four key areas that investors need to focus on in this context.

Firstly, TJX's European expansion plans are working well, with 6% comparable same-store sales growth recorded in the quarter. European segment margins also increased to 5.2% from 3.5% last year, and given that TJX's Marmaxx (T.J. Maxx and Marshalls stores) currently generates margins of nearly 16%, it's not unreasonable to believe that TJX can increase European profitability in the near future. Europe presents a significant growth opportunity.

Second, its home-goods segment grew profits by over 34% in the quarter, and given the resurgence in the U.S. housing market, TJX can expect more to come in the future. Home goods now contribute 9.4% of segment profits from a figure of 8% last year.

Third, one of its objectives is to widen its appeal beyond its traditional customer base by marketing itself more to younger consumers. Indeed, on its conference call, it declared that the plans were working.

Our increase in customers is coming from a younger group of customers" and "we're absolutely bringing in younger customers. That's where our increase is coming from.

The final objective is the second-half launch of an e-commerce-enabled T.J. Maxx website. Plans for the site were described as being 'on-track,' and since retail companies like VF Corp are generating good growth from e-commerce expansion, the future looks bright for this initiative.

What about Ross Stores?

While the first chart indicates that its fortunes are very similar to TJX, there are some differences. Ross isn't chasing e-commerce growth or making aggressive international expansion plans, but it has managed to generate some impressive traffic growth over the last few years. In addition, its focus on improving execution has lead to its profit margin rising to 8.4% from 7.7% last year, and this compares favorably to TJX's overall profit margin of 7.4%.

However, the one area where Ross under-performed TJX was in its home-goods sales, which only rose inline with its total sales growth. Similar to its rival, Ross Stores continues to beat its own guidance.

source: company presentations

Where next?

Essentially, both companies are executing well in their core U.S. off-price clothing markets. While other retailers are suffering from the ongoing cautiousness of the consumer, the off-price concept seems tailor-made for consumers seeking opportunities to avoid paying full price.

In addition, running an off-price retailer requires a significant amount of experience in purchasing inventory and merchandising.  Arguably, this provides TJX and Ross with some significant barriers to entry that aren't replicated across many other parts of retail.

It's been a difficult year for the retail sector with consumers being challenged by payroll tax increases, sequestration fears, tax-refund delays and some unusual weather conditions. However, both companies have demonstrated that they can outperform in a difficult retail environment, and with the U.S. economy continuing to generate moderate GDP growth of 2% to 3%, the off-price retailers have longer to run.

Ross Stores Has Further To Run, But Not Much More

The U.S. economy remains in slow and unspectacular recovery mode, but this fact should not deter investors. Making money in the markets is not just about buying/selling stocks in line with the economy but, in my opinion, more about finding stocks that can surprise on the upside within an understanding of the future economic climate.

I think the off-price retailers are a good example of the sort of stock that has the potential to do well in this environment. In this article I’m going to focus on Ross Stores (NASDAQ: ROST). I will discuss its recent results and suggest some other names to look at.

Ross offers good value -- well, just about

I last looked at the stock in March in an article linked here. Since then the stock has done well, and I think it has a bit further to run. The recent rise is putting pressure on it to continue to outperform, but the good news is that current trading is pretty good.

As ever with Ross Stores it is worth noting that it tends to be conservative with its guidance. In the article linked above I referenced its guidance of 1-2% growth in comparable same store sales growth and suggested that it might beat that number. In the end the number came in at 3% for the quarter, and the guidance of 1-2% for the next quarter (and the full year) remains intact. Traffic was flat but an increase in the average basket size helped gross margins carry on their impressive performance.

Here is a table comparing its guidance with what it has reported:

As the notes in the graph suggest I think the market seems to expect Ross to beat its conservative same store sales guidance each time. If true, this could put pressure on the stock price should it fail to beat the range given for the next quarter. 

The 1-2% guidance is obviously something catching on in the industry because its rival TJX Companies (NYSE: TJX) tends to forecast in a similar manner.

What about the competition?

TJX is a useful company to compare and contrast with Ross because its same store sales came in at the top end of guidance with 2% growth; but the good news was that it guided towards 2-3% for the current quarter. The other interesting comparisons are that TJX is aggressively expanding into Europe and that it plans to launch an e-commerce initiative in the second half. By way of comparison Ross’ management declared that the economics of an e-commerce operation don’t ‘add up’ for the company. Will it work for TJX? And will either of these companies change their minds about e-commerce?

TJX’s home goods sales have been doing well while Ross had some disappointments last year and is somewhat playing catch-up. No matter, its management declared itself as ‘feeling good’ about the changes and said they were on track.

Another company worth watching in this context is J.C. Penney (NYSE: JCP). Frankly anyone would struggle to put this company’s difficulties as eloquently as Howard Davidowitz has done over the years. No prisoners taken when this guy gets fired up!

The good news is that the company has grasped the gauntlet and is starting to offer the kind of promotions that many think it needs to. Furthermore, it is pinning its hopes on expanding its home goods sales. Both of these activities will potentially increase competition for TJX and Ross, and investors need to watch events closely. The difficulty that J.C. Penney has is that it is exactly in the kind of mid-range retail space that this economy has ravaged.

Where next for Ross Stores?

In conclusion I think the stock has a bit more to run and I'm holding for now. Ross forecast EPS of $3.70-$3.81 for the full year, which puts it on a forward PE of around 17.2x as I write. In addition, this is a heavy investment year with a step-up in capital expenditures to around $670 million. The implied EPS growth rate of around 6.4% may not seem like much, but lets recall that last year's earnings contained a positive contribution of $0.10 from an extra week's sales. If you strip that out then the EPS guidance is for a more respectable 9.4% increase.

I think a target price of around $69 is reasonable given the risk of the extra capital expenditures (mainly to build out two new distribution centers), the possibility that J.C. Penney might get its act together and the chance that the market may be currently pricing the stock to keep beating its own guidance.

Why TJX Companies Remains Good Value

The retail sector has been one of the hardest to call in recent years. The bifurcation in prospects between the haves and have-nots in the U.S. has created an atypical situation within the sector. Whereas in previous recoveries, the general drift is upwards across the board, this recovery has seen a strengthening at the high end and a general movement towards ‘trading down’ in the mid range. Within these shifting sands, one island of retail has offered strong prospects.

Specifically, the off-price retailers have demonstrated continued strength and The TJX Companies’  latest results are confirming this trend.

TJX Companies reports sales growth at the high end

Earlier in May TJX Companies had reported same-store sales growth of 2% in the quarter and declared that its same-store sales in April came in at the high end of guidance at 8%. This positive trend appears to be in place as the company declared that its May sales were off to a ‘strong start.’

As ever with TJX Companies, it is worth noting that its guidance tends to be conservative. I discussed this issue at more length in an article linked here. In rote like fashion, its management tends to guide towards 0%-2% in same-store sales growth. However, they came in at 2% for this quarter and the guidance was 2%-3% for Q2. All of this makes it rather surprising that it kept its full year guidance at 1%-2%. Upside to come?

I’ve broken out the revenue trends within its segments.

And in order to see how TJX makes its money, here is a breakdown of its segmental profit for the quarter.

Clearly, it is still largely a story of Marmaxx (T.J. Maxx and Marshalls) and its prospects are largely guided by the retail movement towards trading down. TJX is not alone in this. Indeed, Ross Stores has benefited from exactly the same trends. Furthermore a retailer like Nordstrom is expanding its lower priced Rack stores in order to react to the new retail reality. I’ll come back to these companies in a moment, but for now I want to look at some of the interesting other growth drivers that TJX has going for it.

TJX Companies’ other growth prospects

While the reliance on Marmaxx is well understood, TJX has some interesting growth drivers going forward

• Europe presents significant growth prospects. The competition in the off-price market is a lot less and Europe’s economic difficulties are creating growth opportunities. The U.K. has long been a strong market for TJX, but Germany was cited as doing ‘very well’ with the potential to expand to 350 stores from 50 at present.

• Home goods in the U.S. have the potential to grow in line with the recovery in the housing market. Its segmental margins increased 120 bps in the quarter and the opportunity to cross sell home goods to its clothing customers is significant. It is the right category at the right time.

• TJX also has growth opportunities from expanding its appeal to male and youth customers

• It is launching a large scale e-commerce initiative in the second half of 2013, of which it claims to have made minimal assumptions within its growth projections.

Many of these plans have things in common with other companies in the retail sector. For example Coach  is trying to deal with the problem of rivals like Michael Kors encroaching on its affordable luxury market by focusing on non-core categories for its growth. In particular, its initiatives in footwear, apparel, and men’s categories are a recognition that retail outlets need to be innovative in developing new revenue streams. In common with TJX Companies' plans to target men, Coach is trying to tap into the growing market for male fashion and grooming.

Similarly, Nordstrom’s collection of growth plans center on expanding its e-commerce, in-store mobile point of sale devices, and Rack stores; all of which requires significant capital expenditures (around $3.7 billion) over the next five years. It is an ambitious plan and adjusting to the new retail environment is the right thing to do, but investors need to be confident in its execution.

Where next for TJX Companies?

The stock has had a nice run and I note some profit taking after the results. I like the stock and have a target price in the mid $50’s. Analysts expect double-digit earnings growth for the next couple of years and I like its long-term earnings prospects from the growth drivers discussed above.

A forward PE of around 18x may appear expensive, but it has converted over 140% of its earnings into operating cash flow on average for the last three years. Its business model is cash generative and it has good growth prospects. If it can generate another $2 billion in free cash flow this year, this would put it on a forward free cash flow yield (as I write) of 5.4%. That’s good value for its long-term prospects.