Ross Stores Inc (ROST) — Q3 2018 Earnings Call Transcript

Good morning. Joining me on our call today are Mike O'Sullivan, President and Chief Operating Officer; Gary Cribb, Group Executive Vice President, Stores and Loss Prevention; John Call, Executive Vice President, Finance and Legal; Michael Hartshorn, Executive Vice President and Chief Financial Officer; and Connie Kao, VP, Investor Relations. We'll begin our call today with a review of our third quarter and year-to-date performance, followed by our outlook for the remainder of the year. Afterwards, we'll be happy to respond to any questions you may have. As noted in today's press release, both sales and earnings for the quarter were ahead of our forecast despite being up against very strong multiyear comparisons. Earnings per share for the 13 weeks ended November 3, 2018, were $0.91, up from $0.72 for the quarter ended October 28, 2017. Net earnings grew to $338 million, up from $274 million in the prior year. Our third quarter 2018 earnings results include a benefit from tax reform legislation of approximately $0.16 per share. Sales for the third quarter rose 7% to $3.5 billion, with comparable store sales up 3% over the 13 weeks ended November 4, 2017. This compares to a 4% gain in same-store sales for the prior year period ended October 28, 2017. The Midwest and Florida were the strongest regions for the quarter, while men's was the top-performing merchandise category. Though above plan, operating margin of 12.4% for the third quarter was down from last year as higher merchandise margins were more than offset by planned increases in freight and this year's wage investments. For the first 9 months, earnings per share were $3.06, up from $2.36 last year. Net earnings were $1.1 billion compared to $912 million in the prior year. The year-to-date earnings results include an approximate benefit of $0.51 per share from tax reform legislation. Sales year-to-date rose 8% to $10.9 billion, with comparable store sales up 3% over the 39 weeks ended November 4, 2017. This compares to a 4% gain for the 9 months ended October 28, 2017. As we entered the third quarter, total consolidated inventories were up 8%, with average in-store inventories up 9% compared to last year. As planned, store inventories increased due to the earlier Thanksgiving this year. Packaway, as a percent of total inventories, was 41% compared to 46% last year. Similar to Ross, dd's DISCOUNT continued to post better-than-expected gains in both sales and operating profits for the period. Turning to our expansion program. We opened 30 new Ross and 10 dd's DISCOUNT locations in the third quarter completing our 2018 store opening program. We expect to end the year with 1,477 Ross and 235 dd's DISCOUNT stores for a net increase of 95 locations for fiscal 2018. Now Michael Hartshorn will provide further color on our third quarter results and details on our guidance for the remainder of the year.

Thank you, Barbara. Let's start with our third quarter results. Our 3% comparable store sales gain was driven by increases in both traffic and the size of the average basket. As Barbara mentioned, third quarter operating margin of 12.4% was down from last year, though better than forecast. Cost of goods sold for the quarter rose 60 basis points, as a 20 basis point increase in merchandise margins was more than offset by 50 basis points of higher freight costs and increases of 15 basis points each from buying and distribution expenses. Occupancy costs were flat for the quarter. Selling, general and administrative expenses during the period increased by 30 basis points due to the previously mentioned wage investments. During the quarter, we repurchased 2.9 million shares of common stock for a total purchase price of $278 million. Year-to-date, we have bought back a total of 9.4 million shares for an aggregate price of $807 million. We remain on track to buy back a total of $1.075 billion in common stock during fiscal 2018. Let's turn now to our fourth quarter outlook. As reported in our press release, while we hope to do better, we continue to project fourth quarter comparable store sales to increase 1% to 2% versus our strongest prior year comparable store sales gain of 5%. We are now forecasting our earnings per share to be in the range of $1.09 to $1.14, which includes a one-time non-cash benefit of approximately $0.07 per share related to the favorable resolution of a tax matter. This updated guidance compares to earnings per share for the 14 weeks ended February 3, 2018 of $1.19, which included a per share benefit of $0.14 from a one-time revaluation of deferred taxes and $0.10 from the 53rd week. The operating statement assumptions for the holiday period guidance include the following. Total sales are projected to decrease 1% to 2%, and operating margin is forecast to be in the range of 12.6% to 12.8% versus 14.6% last year. This guidance reflects a negative impact from the additional week last year, which benefited sales by $219 million and operating margin by 70 basis points. Net interest income is estimated to be about $3.6 million. Our tax rate is planned at approximately 19% to 20%, which includes the aforementioned one-time tax benefit. And we expect average diluted shares outstanding to be about $370 million. Based on our year-to-date results and projected fourth quarter guidance, we are now planning earnings per share for the full year on a 52-week basis to be in the range of $4.15 to $4.20. Now I'll turn the call back to Barbara for closing comments.

Thank you, Michael. Looking ahead to this year's holiday season, while we hope to do better, we believe it's prudent to maintain a somewhat conservative posture entering the fourth quarter. As previously mentioned, our projected same-store sales growth of 1% to 2% is on top of robust multiyear gains. In addition, we expect another intensely competitive holiday season, both in brick-and-mortar and online. Nonetheless, we remain confident in the strength of off-price and, most importantly, our ability to perform well within this sector. As long as we remain focused on the careful execution of our strategies, we believe we can continue to achieve solid gains in both sales and earnings as we have for some time now. At this point, we'd like to open up the call and respond to any questions you might have.

First off, do you have a view you could share on the health of just a broader retail channel into holiday? And then, Mike, could you speak to the moving pieces you'd expect within gross margin for 4Q? And then maybe anything to keep in mind for going forward?

Sure. A view of the health of the broader retail channel? Yes, just how you're thinking about pricing and inventory levels, the full-price channel. Pricing. And the full-price channel? Okay. I think this fourth quarter will be as fiercely competitive as it's been in the past. So in terms of pricing, my expectation would be is that there'll still be tremendous promotions and that that's what people used to drive the business. In terms of just a general health overall of the channel, I mean, obviously, there's more money in the economy. And so one would expect that consumers would be spending, but I think it remains to be seen. And again, I really believe it's going to be highly promotional again; and the AUR, it depends. But I think it will be promotional.

On the fourth quarter guidance and some of the trends. So as we mentioned in the remarks, gross margin was down 60 basis points for the quarter and that was driven by higher merchandise margin that was offset by ongoing freight cost inflation. I would expect more of the same going into the fourth quarter. Freight costs will continue to be a headwind at similar levels. We'll also continue to see wage deleverage. As a reminder, we increased our minimum wage to $11 midyear, so the impact is greater in the back half than in the front half.

Great. And just any moving pieces within packaway that you'd expect?

No, for the quarter, packaway was relatively neutral, and our guidance assumes it would be neutral in Q4.

What was the size of the wage investment in the third quarter, and should we anticipate a similar challenge in the fourth quarter? Looking at the broader picture as we progress beyond this year, is there any reason to consider that a 3% comparable sales growth won't continue to serve as the leverage point for selling, general, and administrative expenses? Are there any potential challenges or benefits that might affect this outlook?

Sure, Matthew. Regarding SG&A, it decreased by about 30 basis points due to wage investments. I anticipate a similar or slightly higher impact in Q4. In Q3, SG&A was actually lower than our guidance thanks to effective cost control. We won't comment on 2019 at this moment, but we do expect to continue facing wage and freight inflation. However, we will also seek efficiencies in our business to counter these costs, and we will provide more details during our year-end conference call in early 2019.

Great. Michael, can you discuss the freight inflation that has been ongoing for a couple of years? I believe it really escalated this year, and I am unsure if it began to change in the second quarter or more in Q3. I want to understand the potential pressure we might face in the coming years. I know you aren’t providing guidance for 2019, but any insights on the trends in freight would be appreciated. Additionally, I wanted to inquire about the overall retail environment. I heard about a department store in the Midwest that closed down. Are you noticing any benefits for your stores, especially those in colocation with that retailer? Could this situation create more opportunities for you to develop new brands or acquire new inventory in the coming year?

On freight costs, Kimberly, it's difficult to make a definitive statement. Like all markets, it will eventually reach some sort of balance, but predicting when that will occur is challenging. There are several factors contributing to freight costs this year, including very tight capacity, higher rates due to a shortage of truckers and drivers, and the impact of a recovering economy on capacity. Additionally, regulations regarding the electronic monitoring of drivers and rising diesel costs, which are up 20% year-over-year in the third quarter, contribute to the situation, marking a three-year high. We will have to see how things develop next year, but for now, we anticipate Q4 will resemble Q3 closely.

In response to your question about store closures at other retailers, I would say that when another retailer shuts down, it generally benefits the remaining retailers. The business from those closures has to go somewhere, so you would anticipate that the existing retailers gain some advantage. As other retailers close or liquidate, we expect to capture some of that business. While it's challenging to determine the exact impact, it is unlikely to be significant in any given year. However, we believe this trend will be advantageous in the long run.

And in terms of supply, usually store closures generate some form of supply.

I guess 2 questions. One, curious, Michael, about in-store inventories, I guess, up 9%. Curious what they would have been ex the Thanksgiving timing and sort of how you're thinking about in-store inventory levels maybe from here heading into next year from a philosophy perspective? And then maybe Barbara, do you want to talk about as you lap last year's very healthy 5% comp in the fourth quarter. Maybe what are 2 or 3 things that the organization is doing differently this year, whether it's marketing, product flow, mix, et cetera, to lap last year's strong performance?

Brian, on the inventory, as we mentioned in our remarks, Thanksgiving is a week earlier this year. So we did flow inventory without. So in-store inventory was up about 8%. Without that, inventories would have been relatively flat. And as far as expectations for running the business going forward beyond this 53rd week comparison year, we'd expect inventory levels to be relatively flat.

And in terms of things we're doing to be up against the strong comparison. We're really building out on what worked well for us in the past. We've had many years of robust gains in the fourth quarter. So this isn't the first time we're up against the strong number. And really what we're building on is further opportunities in gift giving, because that really what drives the sales in the fourth quarter, and we view that as something that goes on in the entire box. Obviously, home is a place where there's always strong gift-giving opportunities, but we feel last year, we were successful in other areas in gift giving and so we're building upon that.

I wanted to just follow up on the packaway numbers, which were down for the second quarter in a row as a percentage of inventory. Is there anything going on with what you're seeing in the market? Or what you're deciding to hold in packaway versus flow immediately?

No, there's still strong availability in the market, so we haven't seen a drop-off. The packaway can fluctuate from quarter to quarter and month to month based on what's available. I believe that what we're including in packaway is appropriate. There are specific criteria for what we include, and we aim to feel just as good about it when it comes out as when it goes in. I wouldn't say there is any change in our approach to packaway. This quarter, as Michael mentioned, we flowed packaway earlier due to Thanksgiving being a week earlier, which is contributing to the current situation.

On the 3% comp in 3Q, very solid against tough compares. I know you said, men's kind of lead. Just curious of any other kind of takeaways or details on the top line in 3Q, especially as it relates to beauty and home, efforts and kids and outerwear. Just kind of curious what you're seeing on those fronts. And also, just on the merchandise margins being up. If you could just talk about the drivers and sustainability potential for additional gains ahead?

Sure. During the quarter, men's was our top performer. Shoes and accessories also exceeded the average performance of the chain. Home performed in line with our expectations. In terms of apparel versus non-apparel, their performances were quite similar for the quarter. Regarding merchandise margins, they increased by about 20 basis points, driven by our ability to chase business opportunities, above-plan sales, and improved purchasing strategies. Our approach has consistently been to start with a conservative sales projection. If we can pursue business opportunities, we can enhance merchandise margins. That’s our perspective moving forward.

So my question is about, you talked about how it's going to be a pretty promotional 4Q environment. Do you see that more in relation to sort of the full-price competitors or more from the off-price competitors? Secondly, how much would you be willing to sort of trade the merchandise margin, which has been very strong, in exchange for better sales?

The promotional environment for full-price items has historically been focused on promotions, and I believe this trend will continue. We've noticed an increase in promotional activity over the past few weeks. As for off-price competitors, they are presenting their values similarly to us, but I don't see that as the same approach. There is no significant promotion or point-of-sale activity among them. We are confident in the strong values we are offering on the sales floor. However, I won't compare myself to my two largest off-price competitors. What was the second part of your question?

If you felt like you wanted to drive sales, how much could you try to trade merchandise margin for sales?

I don't believe we need to compromise merchandise margin for sales. Our large merchant team and extensive vendor base work diligently every day to secure strong values. There is a delicate balance between maximizing profits and providing compelling bargains to our customers, and that is something we manage daily. Our merchants are very attuned to this dynamic. I don't think we can simply adjust things like the initial markup and expect direct correlations, as our merchants are actively sourcing the best possible values and analyzing what both full-price and other off-price retailers are doing. Our focus is on delivering value, and that will continue to be our strategy moving forward.

Curious if you could talk about the sales cadence during the quarter. And I'm not sure if you mentioned, whether or not the weather helped or hurt you, if you can make any comment on weather during 3Q. And I'm also curious just near term, any impact from the fires out West? How many stores are impacted? And do you expect that to be any sort of a material impact to 4Q sales?

We are not able to comment on the potential impact of the fires on our fourth quarter at this moment. Regarding the weather in the third quarter, it did not significantly affect us. We did experience various challenges, including two major hurricanes last year followed by a recovery, and another hurricane affecting the Southeast this year. Overall, the weather had a neutral effect for the quarter. In terms of trends, we saw stronger comparisons earlier in the quarter, but late in Q3, we were dealing with the rebound from the two major hurricanes last year.

I know you mentioned some of the cost factors. However, I’d like to look a bit beyond just the fourth quarter. As we approach next year, will there be an impact from the changes in lease accounting? A competitor brought this up, and I wanted to get your perspective. Additionally, regarding tariffs, could you share your insights on industry behavior? Is there a previous period you could reference that might illustrate how tariffs have influenced your business, similar to past global macro events? This could assist in understanding how companies in the industry manage their inventory and your outlook on inventory challenges if border issues arise.

On lease accounting next year, yes, there is some impact. It's noncash related. It's purely accounting. And again, we would look to find areas in the business to offset those additional costs.

Regarding tariffs, I don't believe there is a historical event that serves as a suitable analogy. In general, the current tariff situation raises questions about whether there will be tariffs, when they will be implemented, which items will be affected, and how long they will remain in effect. This uncertainty creates a challenging environment. Typically, off-price businesses perform relatively well in uncertain conditions, but we don't have a specific historical event to compare it to.

We had a question on home. Thanks for the color on some of the category drivers of the comp. We noticed that home was in line with some of the other categories this quarter having outperformed the rest of the business for some time. Is there anything specific that you can talk to there? Or any change to the strategy of increasing home penetration across the business?

Home was up against its very solid results last few years. And so the performance relatively in line with the chain, of above-plan chain sales for the quarter, felt okay. In terms of looking at future, looking at assortments, we're always looking to grow new businesses and look within our 4 walls to improve the assortments. So in terms of specifics, I won't go into specifics. But we do think home is a growth area. You know it's very broad-based, a large amount of different products are conglomerate into there. So we do feel good about it. And again, always looking to improve it.

Most questions have been answered, but I guess I'll just throw it out there to the team. Just curious if you guys have looked into the tax dynamics for your consumer, mainly in early '19? Seems like the low-end consumer could have a very favorable cycle ahead for them. So just kind of curious, I want to ask if you guys have dug into that at all or had any thoughts?

I guess we have looked at it and obviously, that would have an impact on the first quarter. But we'll have more to say about that going into next year. The tax rebate cycle has changed pretty dramatically over the next couple of years. So we'll have to see what we build into our expectations when we give our year-end results at the beginning of next year.

I just wanted to ask about the composition of the basket. I think in the past you've called it out as being UPT driven. Just wanted to know if there's anything to call out in terms of AUR ticket?

Sure. As we mentioned, the 3% comp was driven by higher traffic. And an increase of the average basket, the basket was all driven by units per transaction. AUR was relatively flat for the quarter.

I'm curious, Barbara, to what extent you can share your thoughts on whether Ross gained market share or simply maintained it in the overall apparel market. The reason I ask is that, while Ross had a good comparable sales performance, it was significantly lower than what we consider its closest competitor this quarter.

Sure. Regarding our performance, I won't comment on our competitor, but over the past one, two, and three years, we faced comparisons of 3%, 4% in 2017, and 7% in 2016. Our overall comparable performance was 14%. Measuring our share in apparel relative to our competitor on a quarterly or yearly basis is challenging for us. However, I can say that apparel has significantly grown over the years alongside our comparable performance. Comparing ourselves to competitors is difficult and not something I would typically engage in, but it's clear that apparel continues to grow.

Just a couple category questions. Can you talk about what you're seeing in the toy category and just your expectations there, especially into the holiday? And I was wondering if you could maybe talk about your footwear business, men's shoes, women's shoes and boots and just sort of the opportunities that you see in that category as well?

Sure. We see some opportunities in the toy category due to recent bankruptcies and closures, but toys make up only a small portion of our overall business. Historically, toys have a bigger presence for us during the holiday season, and that will be the case this year as well. Overall, while it's still a small segment for Ross, there are opportunities. Regarding our footwear business, it has exceeded the chain average in the third quarter and is performing well across all three areas. The mix is quite broad, and the boot segment has been strong, especially with the recent weather patterns. This performance has been consistent for several years now, showing strong execution and the ability to capitalize on key opportunities.

Great. And just a question on the wages. With the investments that you've made, do you feel like you're ahead of the curve just sort of keeping up in terms of the competitiveness? And are you seeing any challenges to sort of filling your new store openings with employees?

So we feel good about where we are with the workforce today. Obviously, we've raised wages. And that's the good news for the people that we're looking to hire. And store-by-store, we really haven't seen miscues in filling our new stores.

So I just wanted to follow up on the tariffs situation. And I know it's hard to give a precise estimate particularly with close-outs. But can you just kind of frame how much your product inventory or maybe how many of your 8,000 vendors are based in China? And then how you think about the impact of the tariff that has been announced to date versus what that impact looks like if there's a more sizable extension?

In terms of our 8,000 vendors, the majority of our business involves close-outs, so we are not tracking the country of origin. Manufacturers produce goods wherever they choose, and we purchase those goods. Consequently, I do not have information on what percentage of the 8,000 vendors would be impacted. Regarding the overall impact of tariffs, some business classifications are clearly affected, particularly in the home category and certain accessories, but home is the most significantly impacted. The ongoing trade tensions have created considerable uncertainty in the marketplace and may lead to supply issues in the future. However, as of now, everyone seems to be evaluating their options in response to the tariffs. We are not leading this charge but rather following, and there is no unified vendor strategy since each vendor approaches it differently. We are assessing our actions as needed. Our direct exposure to tariffs is primarily in the home sector, though we do not disclose that specific percentage, and it constitutes a relatively small part of our total sales mix. Therefore, there are many variables concerning tariffs at this moment. The vendor community appears to lack a comprehensive strategy due to the uncertainties involved. If tariffs were to extend to apparel, that would represent a much larger issue for everyone, especially since inflation in apparel has not been seen in many years. This presents certain challenges, and we will address those issues when they arise.

As you think about real estate, where, I think, occupancy was flat this quarter as compared to the leverage of 15 basis points last quarter, what are you seeing on renewals of leases and negotiations? And with these Sears boxes now available, does that provide you with locations that you may want either for dd's for even part of it or for Ross?

In general, we are pleased with the availability of real estate locations. Our real estate team has done an excellent job over the past several years in identifying sites for our store expansion. The store closures by other retailers have certainly contributed to this availability. However, it varies by retailer; some are located in malls, which do not align with our interests since we focus on strip mall locations. Overall, we are quite satisfied, but the impact really hinges on the type of real estate each retailer operates in.

And the fact that occupancy was flat this quarter, is there opportunity to get leverage again? Or, how do you think about it?

So Dana, on the leverage point for the year for occupancy is 3%. Historically, that's been 4%. So we are in a better position this year. Remember that the comp sales and fiscal sales are 2 different metrics this year, because of the week shift. You got more leverage in the first half of the year because the fiscal sales were higher than comp sales, and that reverses in the back half. But for the year, we think occupancy costs or leverage points around 3%.

Just a quick clarification, again, on the topic of the retail environment, I know the question has been asked. But you guys are typically conservative, you've talked about kind of every year being a little bit more promotional, more intense. Do you see that trajectory steepening or is it just kind of a continuation of that? That's my first question. And then my second question is as it relates port bottlenecks related to tariffs, are there any categories where even if you're not directly importing, where you're seeing maybe some full-price retailers have more disruption?

On the retail environment, we believe it's promotional every year. I think there might be some movement from Q3 to Q4, but it’s promotional consistently. This will vary by retailer, depending on their performance and business model. As for port bottlenecks and supply, we haven’t identified a specific area causing significant supply issues. While many manufacturers are bringing goods from China earlier due to tariffs, which affects everyone, we can’t pinpoint one particular category of business significantly impacted. If there is a supply issue, it is likely to be widespread due to the bottlenecks.

You all have done a really good job managing expenses, with headwinds of freight and labor, and using offsets to help mitigate that. Wondering if you can give us a little bit more color on this offsets, what areas they're coming in from, so we can get a magnitude field for that and the categories? And then also second question would be, your holiday initiatives with respect to marketing, spending this year versus last year, is it about the same in terms of that spend or maybe any color there?

On offsets, there is no one-size-fits-all solution. We examine efficiency throughout the company, including payroll in the distribution centers and stores. We have a strategic sourcing team that focuses on how we acquire products and services, specifically non-merchandise items. We're consistently seeking efficiencies in our operations, which can add up over time. There are various initiatives in place to stay ahead of inflation, and we will continue to focus on this as we move into next year and beyond.

And then on the marketing spend? Yes. Sorry, go ahead.

Yes, sorry. Second part of your question on marketing. No material changes in the amount of marketing spend in the fourth quarter.

So just given the dynamic with freight, do you foresee any additional investments you might need to make around the store DC network to maybe increase efficiencies?

Sure. On the DC network, our investments there certainly, with higher wages, it presents us an opportunity to invest in automation, and we'll do that over time, for efficiencies. The next reason to invest in the network is capacity-related, right now we think we have the capacity and would start the next distribution center over the next couple of years.

Have you observed any significant advantages from stores located near some of the recent bankruptcies? It doesn't appear that this is the end for those bankruptcies, so I am curious if you've noticed any rise in customer traffic or benefits due to those closures.

No. This is a general observation. When a store is closing during its out-of-business period, we might see some negative effects on local stores. However, after the store has closed, we usually experience an uplift. As I mentioned earlier, store closures of competitors tend to benefit our business, but they typically do not have a significant impact in any single year. It is over the long term, as store closures accumulate, that we generally see it become a tailwind for us.

Barbara, could you elaborate on your earlier comments regarding your expectations for the holiday season? It seems like it will continue to be very promotional, similar to last year. We're hearing from many retailers that inventories are in good shape and merchandise margins are improving. In the soft line sector, including your company, could you provide more insight into why you believe it will be quite promotional again? Additionally, can you share any updates on your new marketing strategy? I know you mentioned that marketing spend is flat, but are you exploring any new digital or social marketing approaches that you can discuss?

Regarding the holiday season, it has typically been a promotional period. Even though inventories might be tighter, we have an additional week this year, and things are progressing quickly. If we consider both online and physical stores, as online retailers become more competitive and start their promotions early in the fourth quarter, physical stores will need to respond similarly. Additionally, Q3 performance varied among department stores; some may promote heavily while others may not. However, I would be quite surprised if we exit the quarter without a promotional atmosphere, especially in the last week to ten days, as shoppers are already starting their holiday buying with Thanksgiving approaching sooner than usual. We've noticed an increase in promotions in recent weeks as retailers lift their point-of-sale efforts. Although there may be less inventory available, the need to drive sales is a top priority, and historically, promotion is what drives those sales. This is the basis for my conclusion.

Omar, regarding your question about marketing, I would divide it into two parts. Firstly, concerning our marketing strategy and message, it has remained consistent over time. We continue to communicate that we offer the best values in apparel and home fashions, and that message will not change. However, the channels we use to communicate this message to customers have evolved. We have always understood that word-of-mouth marketing is our most effective approach. Over the past few years, we have been experimenting and investing in various new marketing methods, such as social media. We believe these tools represent a modern take on word-of-mouth marketing. I would consider some of these initiatives to be in the early stages, but it is clearly the direction our marketing is heading.

Thank you for joining us today and for your interest in Ross Stores. Have a good day.