TJX COMPANIES

Ross Stores

Bet on Ross. It has more to gain, and improvements are afoot. We'll look at them in a moment. The stock turned up recently in our Three-Point Value screen.

The Three-Point value screen is so named because it relies on a trio of valuation measures: the price/earnings, price/sales and price/cash-flow ratios. Together the three serve to eliminate companies that look cheap for the wrong reasons. For example, a home builder that seeks to reduce inventory through deep discounting, as many are doing at the moment, might generate ample sales and turn up on a search for low P/S ratios. But its earnings would suffer, making its P/E ratio less flattering. A crafty manufacturer seeking to hit sales and earnings targets can simply offer generous financing on its orders: order now, pay whenever. But it would be betrayed by its cash flow and corresponding P/CF ratio.

In addition to modest valuations our screen looks for manageable debt levels, projections for healthy earnings growth and a general dearth of Buy and Strong Buy recommendations from analysts value stocks, after all, ought to be somewhat unpopular. See our screen recipe for details on all the demands and use our stock screener anytime to run the search for yourself. It recently produced eight survivors from a starting database of 8,000 companies.

Based in Pleasanton, Calif., Ross operates 773 stores that bear its name and 26 dd's Discounts. (I'm willing to concede the lower-case initials, but I'm overruling the all-cap "discounts" the company uses in spelling its name.) The stores are spread through the West and Southeast. The chains carry similar items, clothes, footwear and bed-and-bath items, but dd's focuses mostly on less-expensive brands for a lower-income customer.

Ross suffered from what analysts call self-inflicted merchandising problems in 2004 and 2005. Poor reporting led to high shipping costs, low product margins and too much shrink. (Shrink is an industry term for the difference between what a computer says is on the shelves and what a physical count turns up. Stolen goods, for example, count as shrink.) Last year the company invested in new software and inventory systems. The improvements are evident in the company's financial results. Third-quarter profits reported Nov. 14, for example, increased 21% year-over-year on a 4% improvement in same-store sales (that is, in sales for all but newly opened and acquired stores). Management credited two cents of the company's 31 cents-a-share earnings to lower-than-projected shrink.

Mark Montagna, an analyst with Albany, N.Y., investment firm C.L. King & Associates, says investors should expect Ross to produce 0.3 to 0.4 percentage point of annual operating margin increases over the next several years. He counts more than two percentage points of margin that can be reclaimed simply through continued improvements the company's distribution system, product margins, shrink and freight costs. Also, sales and earnings at dd's are tracking ahead of the company's plan, but the chain is at present too small (26 stores, recall) to make proper use of its fixed operating costs. Management plans to open more dd's stores in 2007 than the six it christened last year, including the chain's first stores outside of California. In mid-October Ross announced it would buy 46 store sites in six states from Albertson's, the grocer.

Wall Street expects Ross to increase its earnings by 15.5% annually over the next five years, according to consensus data from Reuters Research. That's 3.5 percentage points ahead of the forecast for TJX. Divide Ross's P/E ratio by its earnings growth projection and you get a PEG ratio of around 1.1. That's a discount of a quarter to TJX and nearly a third to the broad stock market. Ross's P/S and P/CF ratios of 0.8 and 12.6 represent discounts of more than half and just a smidgen, respectively, to the broad market an off-price retailer, indeed.