Thursday 5th February, 2015

6.30pm

Fundamental Analysis Department

Consumer Industry on U.S. Luxury Goods

Content

• Introduction

• Porter’s 5 forces

• Industry drivers

• Current industry outlook

• Introduction of Ross Store

• Valuation of Ross Store

Introduction for luxury good

• Goods that are not a necessity but are highly-desired within a culture or society

• Demand for these products is fuelled by desires rather than needs

• Evoke certain perceptions of reaching the upper echelons of society

Examples of luxuries

Porter’s Five Forces Threat of New

Entrants

Bargaining Power of

Buyers

Threat of Substitutes

Bargaining Power of Suppliers

Competition within

Industry

Threats of New Entrants: Low

• Engine that drives the sale of luxury goods is its brand

• People go for brands that have reputable statuses

• Difficulty in penetrating into the highly saturated luxury goods market

• Large companies enjoy economies of scale

Bargaining Power of Buyers: Low

• Depends on the brand

• Lowering the price significantly may actually signal a drop in quality or old designs

Threats of Substitutes: Low

• Switching costs to consumers

• Virtually no substitutes for luxury goods as each brand is unique and cannot be replaced with another brand

Bargaining power of suppliers: Moderate

• Relationship with the suppliers is very important

• Increased risk of switching to a lower quality supplier

• Luxury companies are huge conglomerates

Overview of the industry drivers

• Income level

• Market segmentation

• Embracing E-commerce

Income level

Market segmentation

Casual Fashionable Classic

Benefits of E-commerce

• White collar workers often tied up with their work

• Low capital to set up

Recent Industry Outlook

Dip in Luxury Sector

Reason: • Federal Reserve hinted

delays in interest rate hikes • Investors think negatively

about US economic condition.

• Believe Luxury Goods will not do well

• Hence flight to safety

Recent Industry Outlook

But Fundamentals Remain Strong

The greater the amount of disposal income, the greater the number of people can afford luxury goods.

The greater the amount of consumer spending, the greater the likelihood luxury goods will be bought.

ROST: ROSS STORE (BUY) Target Price: USD 89.19 (+9.9%) as of 26 October 2014

Business Segments

One of the largest off-price apparel and home fashion chains in the U.S.

1194 Stores 144 Stores

Offers designer apparel, accessories, footwear, and home fashions for the entire family and savings of 20% to 60% off department regular price.

Offers 20%-70% off moderate department and discount store regular price.

Brands Revenue Break-Down

Ross’Business Model

ROSS Few classification

but large selections within

each classification.

7900 vendors and manufacturers

network.

Direct purchase

No fringe benefits

Opportunistic buying

Competitive Advantage 1

2009 2010 2011 2012 2013

%ofCOGSoversales 74.20% 72.80% 72.50% 72.10% 72%

%ofSGAoversales 15.70% 15.60% 15.20% 14.80% 14.90%

EBITMargin 10% 11.40% 12.20% 13% 13.10%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

Percentage

Cost&Opera ngMargin• Decreasing Cost of

Goods Sold (COGS). • Increasing operating

profits.

The Driving Forces:

1. Better procurements of goods.

2. Lower Sales, general & administrative cost resulting from centralized merchandising, marketing and purchasing.

3. Lower operating cost due to • Workers are non-unionised.

• 48900/66300 (74%) of labour are part timers no full time benefits.

• Customer self-service.

Competitive Advantage 1

Towards more Economies of Scale & Increasing Market Shares

0

50

100

2009 2010 2011 2012 2013

Net increase in store

0

500

1000

1500

2009 2010 2011 2012 2013

No of stores

0%

5%

10%

1 2 3 4 5

Comparable store sales increases (52 weeks)

$250

$300

$350

$400

1 2 3 4 5

Sales per average square foot of selling

space (52 weeks)

Competitive Advantage 2

Competitive

Advantage 2

Towards more Economics of Scale & Increasing market shares

the increase

Valuation

Steps in Valuation

1. Choose a method (FTE, WACC)

2. Forecast Revenue Growth

3. Forecast Margins – Income Statement

4. Forecast Turnovers – Balance Sheet

5. Build Pro-forma Statements

6. Determine Discount Rate

7. Discount CF – Intrinsic Value

1. Model: Flow-to-Equity (FTE or FCFE)

NI – Net Capex – Change in NOWC + Net change in Debt

Capex – Depreciation

End Net PPE – Beg Net PPE

1. Model: Flow-to-Equity (FTE or FCFE)

NI – Net Capex – Change in NOWC + Net change in Debt

Ending NOWC – Beg NOWC

1. Model: Flow-to-Equity (FTE or FCFE)

NI – Net Capex – Change in NOWC + Net change in Debt

New Debt Issued – Debt Repaid

2. Forecast Revenue Growth

Macroeconomic Conditions

Industry Specific Metrics

• Median income growth • Consumption trends • GDP growth

• Store count growth • Sales per square foot • Same store sale

Revenue Forecast (2 stage)

Sales Growth (2015) 10.1%

Long-term (10 years) 2%

Tapering Linear / Exponential / S-curve

3+4. Forecast Margins & Turnovers

Assumptions

• Profit margins worsened slightly due to increasing competition from online retailers – Proportion of cost increased with respect to revenue

• Asset turnover in line with long-term average

• Special case: US$250m note issue in 2014

5. Build Pro-forma Statements

50%

52%

54%

56%

58%

60%

0

1

2

3

4

5

6

7

8

2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026

Bill

ion

s

Pro-forma Balance Sheet Total Liabilities Total Common Equity Debt Ratio

0

5

10

15

20

25

0%

2%

4%

6%

8%

10%

12%

Bill

ion

s

Pro-forma Income Statement Sales (Net), LHS Net Income (available to common), LHS Sales Growth, RHS

6. Determine Discount Rate

• Cost of Equity (CAPM) = 8.54% – Risk-free Rate: 2.3%

• 10-Y Treasury (Sept 2014)

– Market Risk Premium: 6%

– Beta: 1.04 • Obtain peer group’s equity beta

• Derive unlevered beta

• Re-lever at firm’s target debt level

6. Discount Cash Flow

0

200

400

600

800

1000

1200

1400

1600

2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026

Mill

ion

s

Free Cash Flow to Common Equity

Current Price $80.27

1 Year Target Price $89.19

Upside Potential 11.1%

Cost of Equity

9.5% 9.0% 8.5% 8.0% 7.5%

Te

rmin

al G

row

th R

ate

1.0% 73.92 78.66 83.59 90.23 97.38

1.5% 75.72 80.83 86.18 93.44 101.35

2.0% 77.77 83.31 89.19 97.19 106.05

2.5% 80.11 86.17 92.64 101.63 111.69

3.0% 82.81 89.51 96.74 106.94 118.58