Ross Stores: Company-Specific Headwinds Create Unattainable Forecasts

1/1/2010 5/1/2010 9/1/2010 1/1/2011 5/1/2011 9/1/2011 1/1/2012 5/1/2012 9/1/2012 1/1/2013 5/1/2013 9/1/2013 1/1/2014 5/1/2014 9/1/2014 1/1/2015 5/1/2015 9/1/2015 11/1/2005 5/1/2006 11/1/2006 5/1/2007 11/1/2007 5/1/2008 11/1/2008 5/1/2009 11/1/2009 5/1/2010 11/1/2010 5/1/2011 11/1/2011 5/1/2012 11/1/2012 5/1/2013 11/1/2013 5/1/2014 11/1/2014 5/1/2015 11/1/2015 11/1/2005 5/1/2006 11/1/2006 5/1/2007 11/1/2007 5/1/2008 11/1/2008 5/1/2009 11/1/2009 5/1/2010 11/1/2010 5/1/2011 11/1/2011 5/1/2012 11/1/2012 5/1/2013 11/1/2013 5/1/2014 11/1/2014 5/1/2015 11/1/2015 11/1/2005 5/1/2006 11/1/2006 5/1/2007 11/1/2007 5/1/2008 11/1/2008 5/1/2009 11/1/2009 5/1/2010 11/1/2010 5/1/2011 11/1/2011 5/1/2012 11/1/2012 5/1/2013 11/1/2013 5/1/2014 11/1/2014 5/1/2015 11/1/2015 Ross Stores: Company-Specific Headwinds Create Unattainable Forecasts Ross Stores is more economically sensitive than the market believes, yet in the current retail environment trades at all-time high relative an absolute multiples Industry-wide increases in inventories create short-term headwinds to same-store-sales and margins Ross Stores high exposure to California creates significant cost headwinds compared to forecasts for margin expansion Increased competition from traditional players (JWN, KSS, M) in the off-priced market will impact inventory, real estate availability, and pricing A lack of e-commerce and international exposure put ROST in a weaker competitive position After posting one of the few strong Q3 numbers in retail, investors rallied Ross Stores (ROST) stock to historically high levels. Additionally, the stock now trades at not only at a historicallyhigh absolute multiple in what can be considered a fairly weak retail environment, but also at a historically-high relative premium to retail peers. This dynamic is due to market sentiment (short interest less than 2%) that includes: 1. ROST is a counter-cyclical stock that can buck the trend of a weak retail environment and will have ample opportunities to acquire discounted merchandise 2. The company will be able to maintain +3% same store sales growth, and by doing so will be able to continue to increase margins going forward 3. ROST s business model is insulated from the threat of e-commerce 14 12 10 8 6 4 2 0 ROST Historical EV/EBITDA Multiple 24 22 20 18 16 14 12 10 8 ROST Historical P/E Ratio 2.0x 1.8x 1.6x 1.4x 1.2x 1.0x 0.8x ROST NTM EV/EBITDA Premium to Department Retail Index 1.8x 1.6x 1.4x 1.2x 1.0x 0.8x 0.6x ROST NTM P/E Ratio Premium to Department Retail Index

But, in reality, ROST is much less counter-cyclical than the market perceives historically the company has come under the same margin and comp pressures during weak environments and only after periods of pain has been able to reap the benefits of low-cost inventory purchases. Additionally, there are several margin headwinds, including an outsized exposure to CA minimum wage increases, which make the market s forecasts for margin expansion unrealistic in our view. Longer-term, increasing competition in the off-price segment combined with a lack of exposure to international or e-commerce markets creates headwinds to growth and the premium multiple ROST currently trades at. Overall, we believe the market is essentially pricing in the bull case, meaning there is little upside if these forecasts materialize, and significant downside if they do not. Considering the multiple headwinds, we expect the company to miss expectations, and for investors to re-rate the stock more appropriately over the next 6-12 months. Investment Thesis - 2015 looks like 2013, but More Headwinds and a Higher Valuation Those who cannot remember the past are condemned to repeat it. George Santayana The 2 nd half of 2015 for retail is shaping up much like that of 2013 a resilient 1 st half that caused retailers become more bullish on the 2 nd half of the year and expand inventories. Just like 2013, that bullishness for the 2 nd half did not materialize and retailers are stuck with excess inventories and are becoming increasingly promotional this holiday season. First let s take a look at ROST stock performance and same store sales during the 2013/14 time period: Ross Stores, Inc. Daily 52.66 0.00 0.00% 1:00:00 PM VWAP: High: 41.00 Low: 30.92 Chg: -12.67% Ross Stores, Inc. - Price Stock Peaks in Nov 2014 on strong Q3 numbers Stock declines ~30% over the next 9 months due to weaker than expected comps and hire wages 42 40 38 36 34 32.20 32 30 Cvol: 1,071,196 Avg: 3,472,632 Ross Stores, Inc. - Volume Oct Nov Dec Jan Feb Mar Apr May Jun Jul 6 3.76 4 2 0

1/1/2010 5/1/2010 9/1/2010 1/1/2011 5/1/2011 9/1/2011 1/1/2012 5/1/2012 9/1/2012 1/1/2013 5/1/2013 9/1/2013 1/1/2014 5/1/2014 9/1/2014 1/1/2015 5/1/2015 9/1/2015 As you can see, ROST railed on earning in Nov. 13, and then subsequently declined over the next 9 months as comps declined due to and the weak retail environment and increasing labor costs due to minimum wage increases (ROST will face wage increasing starting Jan 1, 2016). Same Store Sales Q4 '12 Q1 '13 Q2 '13 Q3 '13 Q4 '13 Q1 '14 5% 3% 4% 2% 1% 2% Q4 '14 Q1 '15 Q2 '15 Q3 '15 Q4 '15 Q1 '16 6% 5% 4% 3%?? We expect the same kind of stock declines due to what we believe are impending declines in same store sales. What makes 2015-16 worse is that the current decline in apparel retail is being driven by weakness in department stores (ROST biggest competition), not specialty apparel as was the case in 2013-14. Additionally, ROST stock is trading at a significantly higher multiple today (11x EBITDA vs. 9x in 2013). This time around could actually be worse, and we d expect ROST s premium to market to contract as it did in 2013. 2.0x ROST NTM EV/EBITDA Premium to Department Retail Index 1.8x 1.6x 1.4x 1.2x 1.0x 0.8x Thesis Point #1 - Retail Environment Creates Headwinds, Not Opportunities After last week s positive report, many investors have become excited about ROST s opportunity in what is becoming an even tougher retail environment both the opportunity to gain share by serving value-oriented customers and the opportunity to acquire cheaper merchandise as retailers look to rationalize inventories. In general, investors continue to call ROST a counter-cyclical story. In reality, ROST is much less counter-cyclical than investors perceive. The benefits described above may arise several quarters from now, but weaker retail sales/higher inventories are actually a negative for ROST over the coming quarters.

Source: Deutsche Bank Research As you can see above from the great analysis done by Deutsche Bank, higher retail inventories (as a result of weaker than expected sales) actually lead to same store sales declines and gross margin deterioration for off-price retailers like ROST. This intuitively makes sense to reduce inventories, retailers heavily discount, thus increasing competition and eroding the ROST value proposition. This in turn pressures ROST to give up margin before they can make it back on liquidating inventories. The positives for ROST s business model don t occur until inventories start to revert downward (less competitive pressure and the realization of buying opportunities). It does not look like this inflection point will occur for several quarters. Competitive pressures have intensified going into the Black Friday holiday, as Jefferies Research noted that apparel discounting was more aggressive this year as compared to last, with the most aggressive discounting occurring at the major department stores (KSS, M, and JCP all increased discounts by +10% this year). After initial reads on Black Friday showed weaker than expected results, it is highly likely that retailers (especially department stores) will become even more promotional in the coming months. This creates a scenario where it is likely that we see both comps and gross margin weakness trickle down to ROST to a more significant extent than it has in the past. Yet, the market is forecasting an acceleration of ROST s 2-year stacked comp above historical levels. We believe that this is unlikely to materialize. What s more likely to occur is that same store sales revert to, or go slightly lower than the historical 2-year stacked comp of 6% (versus market expectations for ~3%):

Quarterly 2-Year Stack December January April July FY Blended Market Expectations 2014/15 6% 5% 4% 3% 5% 2015/16E 2% 3% 3% 3% 3% 8% 8% 7% 6% 7% My Expectations 2014/15 6% 5% 4% 3% 5% 2015/16E 0% 1% 1% 2% 1% 6% 6% 5% 5% 6% Historical Average 6% Gross Margins will most likely react similar to the same weak-comps period in late 2013/early 2014, where we saw ~30-40 Bps of deterioration YoY: 0.50 0.40 0.30 0.20 0.10 - (0.10) (0.20) (0.30) (0.40) (0.50) (0.60) Gross Margin Impact YoY Q4 '13 Q1 '14 Q2 '14 Q3 '14 Considering the current weak period in retail is more heavily driven by promotional department stores (ROST s primary competition) instead of specialty retail like in 2013, gross margins could come under significantly more pressure during the current cycle. Thesis #2 - Significant Exposure to Minimum Wage Increase in California The majority of Ross Stores employees make minimum wage, and ROST has been noted in the past for having the lowest wages in the off-price sector (as shown by their recent increase to $9 minimum wage to compete with TJX and WMT). Recent increases in wages have slightly impacted operating performance, but wage headwinds are about to accelerate. On January 1, 2016, California will increase its minimum wage to $10 per hour. Most retailers will be impacted by this change, but ROST is disproportionately exposed to California. Analysts have noted the impact, but I believe that the extent of impact will be greater than anticipated.

Not only is ~25% of the company s store base located in California, 60% of its distribution centers, 40% of its warehouses, and 50% of its corporate offices are also located in CA. We do not believe that the market is accounting for the company s significant back-office exposure to California. Though ROST does not break out wages in their filings, if we use a combination of 1) information from competitor TJX (TJX) and industry statistics (wages typically make up ~10% of sales), the CA minimum wage increase will add ~$20-30MM of additional expenses, or about 20-30 Bps. This becomes another hurdle to the market s extremely high expectations (40 Bps margin increase YoY), and therefore the risk that investors could re-rate the stock lower on missed guidance over the coming quarters. The minimum wage is becoming an increasingly important topic in the US. California is one of, if not the most, progressive state in regards to employee rights and compensations. Because of this outsized exposure to wages in CA, it is likely that these headwinds persist for some time. Thesis Point #3 Increasing Competition in Off-Price Will Accelerate ROST has benefited over the past several years by being one of the few retailers that caters to consumers becoming more value-oriented. This first-mover advantage has helped the company achieve above-average revenue growth and increase margins by 700 Bps over the past 10 years (~100% increase).

As in most industries where a first mover creates significant economics by a lack of competition, new competition is entering the off-price sectors, specifically from traditional department store retailers. Over the last 6 months, both Macy s (M) and Kohls (KSS) have announced an expansion into an off-price concept, but like Nordstrom (JWN) has done with its Nordstrom Rack concept. We believe that at best, this increased competition will impair the growth rate of the company s margins (as is the case with most industries), yet the market still expects another 100 Bps of expansion over the next two years. We also believe that increased competition could lead to other negative that include: 1. A reduction in the availability of quality off-price inventory at good prices as large department stores shift excess inventory to their own concepts (effectively cutting out the middle man, ROST) 2. A reduction in the availability of new real estate as large departments stores with prior relationships with developers (especially in growth markets where ROST does not yet have a presence) fight for the quality locations. 3. Deterioration in gross margins (which have expanded 600 Bps over the past 10 years) as price competition increases due to increasing competition. Overall, we think this increased competition will stagnate margins, again putting into question the company s historical-high multiple. Thesis Point #4 E-Commerce is a Bigger Threat than Market Believes One of the bulls other thesis points on ROST is that it is insulated from the threat of e-commerce due to the nature of the business model i.e. shoppers enjoy hunting for deals inside the store. Though this may be true to some extent, the impact of e-commerce is more real than the bulls like to believe.

Source: Nielsen Clothing is the highest penetrated segment of e-commerce, with the two major reasons for purchases being time and value. All over the internet, you can hunt for deals which are usually better than in-store (even ROST) and do so much quicker than driving to the store. Moves by Stein Mart (SMRT) and TJX to move to e-commerce signal that the trend is upon us, yet ROST does not have an e-commerce presence. This is exacerbated by the fact that management acknowledges their customer base skews towards younger buyers, who are more tech-savvy and are more quickly shifting consumption habits to mobile/online. TJX moved into e-commerce two years ago and has already seen outsized growth, yet ROST is late with a response. Like many other sectors of retail, those late to the game (think ANF) have lost market share. Additionally, ROST s new competitors in offprice, KSS/JWN/M, already have omni-channel platforms they can leverage. As the percentage of retail sales continues its shift to e-commerce, ROST will have a smaller addressable market and could become last-mover on this trend. Another point to note on e-commerce is margins. ROST currently has operating margins ~100Bps greater than TJX, but that is mostly due to TJX investments in e-commerce. When we take out costs associated with e-commerce, TJX in-store margins are on par with ROST margins. We believe that this creates a catch 22 for ROST either miss out on the opportunity in e-commerce and lose share to competitors, or invest in e-commerce, thus impacting margins which the market forecasts to increase from here.

Thesis #5 ROST has no Exposure to High Growth Areas (International) We ve already noted that ROST does not have exposure to e-commerce, but the company also does not have exposure to competitor TJX s highest growth segment, International. Besides the fact that on an in-store basis TJX has higher margins (as opposed to the bull case that ROST has higher margins), the fact the ROST has no exposure to high-growth international sales is another reason why TJX (10.5x EBITDA and 18x P/E) should trade at a premium to ROST, not a discount. Additionally, new competitors (M/KSS/JWN) have greater scale and ease to initiate international programs, again putting ROST at a competitive advantage. Another interesting point to note is that market forecasts for same store sales at TJX are the same as they are for ROST going forward (~3% per year). For this to be true, considering the higher growth TJX sees in international and home goods, traditional in-store apparel would have to to be around ~1%, which would be in-line for our forecast for ROST (which has the majority of its exposure in this segment). Financial Projections vs. Street / Valuation For the items described above, we believe that same store sales will not reach ~3% and will instead come more in line with historical comps (based on 2-year stack and retail environment). We are forecasting 1% comps, which means the company will not be able to leverage costs. Due to increased distributions costs (highlighted this quarter), higher wages, and a more promotional environment, we see margin deterioration (much like 2013). Below, we have provided our projections versus street expectations. Note: for all base cases, our valuation multiple is slightly

higher than the company s long-term historical multiple and historic premium to retail peers. For all bull cases, we used the company s all-time high multiple. Financial Projections Vs. Street Estimates Street Forecast My Oct'16E Forecast Ross Stores NTM Oct'13 Oct'14 Oct'15 Oct'16E Base Bull Bear Sq. Footage Growth 6.0% 2.5% 4.5% 3.5% 3.5% 3.5% 3.5% Same Store Sales 3.5% 2.3% 4.5% 3.5% 1.0% 4.0% -2.0% Revenue Growth 9.5% 4.8% 9.0% 7.0% 4.5% 7.5% 1.5% Revenue ($MM) $10,250 $10,750 $11,722 $12,543 $12,249 $12,601 $11,898 EBITDA Margin 15.4% 15.5% 16.0% 16.5% 15.4% 16.5% 15.0% EBITDA ($MM) $1,574 $1,664 $1,875 $2,070 $1,886 $2,079 $1,785 EBITDA Multiple 9.2x 9.6x 11.3x 11.1x 8.0x 11.5x 6.5x Enterprise Value $14,444 $16,056 $21,212 $22,955 $15,091 $23,911 $11,600 Less: Net Debt ($550) ($550) ($273) ($301) ($301) ($301) ($301) Equity Value $14,994 $16,606 $21,485 $23,256 $15,392 $24,212 $11,901 Price Per Share/Target $36.75 $40.70 $52.66 $57.00 $37.73 $59.34 $29.17 Upside/Downside -28.4% 12.7% -44.6% EBITDA Multiple Premium to Retail Peers 1.3x 1.9x 1.1x Operating Income $1,372 $1,437 $1,610 $1,768 $1,641 $1,777 $1,547 EPS $1.96 $2.12 $2.43 $2.72 $2.52 $2.73 $2.38 EPS Multiple 18.8x 19.2x 21.7x 21.0x 15.0x 22.0x 12.5x Price Per Share $36.75 $40.70 $52.66 $57.00 $37.86 $60.10 $29.73 Upside/Downside -28.1% 14.1% -43.6% P/E Multiple Premium to Retail Peers 1.5x 2.2x 1.3x Base Bull Bear Blended Valuation $37.79 $59.72 $29.45 Upside/Downside -28.2% 13.4% -44.1% As you can see above, even under aggressive assumptions and all-time high multiples, there is only ~13% upside left in the stock. But, if the company misses expectations for the various reasons we highlighted above, we could see ~30-45% downside. Because of the catalysts we described above, and the risk/reward profile, we believe that ROST provides a compelling short opportunity. Risks Risks to the short thesis include: 1. Better than expected same store sales 2. Margin improvements by leveraging better comps 3. A delay in minimum wage increases

Note: We believe that same store sales and margins risks are incorporated in our bull case scenario. Catalysts Catalysts for the short thesis include: 1. The announcement of worse than expected comps during quarterly earnings 2. More clarity on costs and guidance during the Q4 earnings call 3. Further declines in retail sales/increasing promotions by competitors 4. Announcements by competitors to accelerate off-price store growth Conclusion In an environment where retail stocks are cheap for a reason ROST has bucked the trend an all-time high multiple, all-time high premium to industry, and forecasts for continued growth and margin improvement. For the items we highlight in this article, we believe this sentiment to be unjustified. ROST has little upside if market sentiment is correct, but significant downside if sentiment is too bullish as we believe.