Ross Stores Inc (ROST) — Q4 2021 Earnings Call Transcript

Good afternoon. Joining me on our call today are Michael Hartshorn, Group President and Chief Operating Officer; Adam Orvos, Executive Vice President and Chief Financial Officer; and Betty Chen, Vice President, Investor Relations. We will begin our call today with a review of our fourth quarter and 2021 performance, followed by our outlook for '22 and the longer term. Afterwards, we'll be happy to respond to any questions you may have. As noted in today's press release, we achieved strong sales results in the fourth quarter despite the negative impact from both the surge in Omicron cases during the peak holiday selling period and continued supply chain congestion. Earnings per share for the 13 weeks ended January 29, 2022, were $1.04 on net income of $367 million. This compared to $1.28 per share on net earnings of $456 million for the 13 weeks ended February 1, 2020. Total sales for the fourth quarter were $5 billion with comparable store sales up 9% versus the same period in 2019. For the 2021 fiscal year, earnings per share were $4.87 on net income of $1.723 billion, up from $4.60 per share on net earnings of $1.661 billion in 2019. Total sales for 2021 rose 18% to $18.9 billion with comparable store sales up 13%. Now let's turn to additional details on our fourth quarter results. For the holiday selling period, the best performing larger merchandise areas were children's and men's, while the Midwest and Southeast were the strongest regions. Similar to Ross, dd's DISCOUNTS trends remained solid during the period. However, their profitability was also negatively impacted by cost pressures related to freight, wages and COVID. At quarter end, total consolidated inventories were up 23% versus 2019, mainly from an increase in in-transit merchandise due to longer lead times from the industry-wide supply chain bottlenecks. Average store inventories were down slightly versus 2019, while packaway merchandise represented 40% of total inventories versus 46% 2 years ago. As noted in today's release, we are pleased to report that our Board recently authorized a new 2-year program to repurchase up to $1.9 billion of our common stock through fiscal 2023. This authorization replaces the $850 million remaining under the prior buyback we announced in May of last year. A total of $650 million of common stock was repurchased under the previous program in fiscal 2021. The Board also increased our quarterly cash dividend by 9% to $0.31 per share to be payable on March 31, 2022, to stockholders of record as of March 15, 2022. The increases to our stock repurchase and dividend program reflect our ongoing commitment to enhancing stockholder value and returns as well as our confidence in the strength of our balance sheet and projected future cash flows. Now Adam will provide further details on our fourth quarter results and additional color on our outlook for fiscal 2022.

Thank you, Barbara. As previously mentioned, our comparable store sales increased 9% for the quarter. This gain was driven by growth in the size of the average basket, partially offset by a decline in transactions. Fourth quarter operating margin of 9.8% was down 350 basis points from 13.3% in 2019, mainly due to ongoing expense headwinds. Cost of goods sold increased 210 basis points due to a combination of factors. Domestic freight rose 100 basis points, and distribution costs increased 70 basis points, primarily due to the previously mentioned supply chain challenges, in addition to higher wages. Merchandise margin declined 50 basis points due to higher ocean freight costs, while buying expenses grew 20 basis points. Occupancy levered 30 basis points on higher sales volume. SG&A for the period rose 140 basis points, again, due to pressure from the holiday-related pay incentives, plus higher wages and COVID costs. Total net COVID-related expenses for the quarter were approximately 35 basis points with a higher impact to SG&A than cost of goods sold. Now let's discuss our outlook for fiscal 2022. As Barbara noted in our press release, 2022 is a difficult year to predict for numerous reasons. We are up against last year's record government stimulus and the lifting of COVID restrictions that led to unprecedented consumer demand, which fueled extraordinary sales gains in the spring of 2021. In addition, we continue to face industry-wide supply chain headwinds as well as external risks from the effects of inflation, both on consumer demand and on costs within our business. As a result, comparable store sales for the 52 weeks ending January 28, 2023, are planned to be flat to up 3% versus a 13% gain in 2021. Earnings per share for 2022 are projected to be $4.71 to $5.12 compared to $4.87 in 2021. This reflects our expectation for sales and profitability to improve as we move through the year given the substantial cost increases we incurred in the fall of 2021. Our guidance assumptions for the 2022 year include total sales are forecast to grow by 2% to 6%. We plan to return to our more normal opening cadence of 100 new locations in 2022 comprised of about 75 Ross and 25 dd's DISCOUNTS. As usual, we expect to close about 10 older stores. Operating margin for the full year is planned to be in the 11.6% to 12.1% range, down slightly from 2021 due to deleveraging on lower same-store sales gains, and again, ongoing expense headwinds, especially in the first half of 2022. Net interest expense is estimated to be $70 million. Depreciation and amortization expense, inclusive of stock-based amortization, is forecast to be about $560 million for the year. The tax rate is projected to be about 24% to 25%, and diluted shares outstanding are expected to be approximately 348 million. In addition, capital expenditures for 2022 are planned to be approximately $800 million. This outlay will fund further investments in our supply chain to support long-term growth and in technology to increase efficiencies throughout the business in order to maximize our prospects to capture profitable market share going forward. Let's now turn to our guidance for the first quarter. In addition to the aforementioned stimulus benefits and strong pent-up demand early last year, we also faced larger headwinds from higher freight and wage costs early in the year. As a result, we are forecasting comparable store sales for the 13 weeks ending April 30, 2022, to be down 2% to down 4% on top of a 13% gain for the 13 weeks ended May 1, 2021. Earnings per share for the 2022 first quarter are projected to be $0.93 to $0.99 versus $1.34 in the prior year period. The operating statement assumptions that support our first quarter guidance includes the following: Total sales are forecast to be down 2% to up 1% versus last year's first quarter. We plan to add 30 new stores, consisting of 22 Ross and 8 dd's DISCOUNTS during the period. We project first quarter operating margin to be 10.2% to 10.6% compared to 14.2% last year. The expected decline reflects the deleveraging effect from the negative same-store sales assumption as well as ongoing expense pressure from freight and wage costs early in the year. Net interest expense is estimated to be $19 million. Our tax rate is expected to be approximately 25%, and diluted shares are forecast to be about 350 million.

Thank you, Adam. As mentioned in our press release, given consumers' increased focus on value and convenience, we have seen favorable sales trends in both our new and infill market stores. As a result, along with the large number of retail closures and bankruptcies over the last several years, we now believe that Ross Dress for Less can expand to about 2,900 locations, up from our prior target of 2,400 and that dd's DISCOUNTS can eventually become a chain of approximately 700 stores versus our previous projection of 600. This represents an overall 20% increase in our forecasted potential to 3,600 stores, providing substantial runway for expansion relative to our year-end store count of 1,923 locations. We operate in an attractive sector of retail, and our mission continues to be delivering the best bargains possible to leverage our favorable market position. Looking at 2023 and beyond, we are targeting a return to double-digit earnings per growth driven by a combination of same-store sales gains, operating margin improvement accelerated new store openings and our ongoing stock repurchase program. In closing, we especially want to thank our approximately 100,000 talented associates throughout the company whose dedication has enabled us to successfully navigate through the unprecedented challenges of the past 2 years. We believe their continued efforts will enable us to capitalize on our opportunities for future sales and earnings growth while also delivering strong returns to stockholders over the coming years. At this point, we'd like to open up the call and respond to any questions you may have.

I wanted to ask about the guidance for Q1 and whether you've seen a better start to the quarter, as well as your expectations of a slowdown following the stimulus phase. I'm curious about your plans for the quarter. Additionally, I would like to know from Barbara what you're observing regarding inventory availability in the market and if you've been able to take advantage of the supply chain volatility that's affecting late deliveries elsewhere.

Kimberly, I'll start with the first quarter guidance, it's Michael Hartshorn. Last year in the first quarter, we experienced a significant acceleration in March and April. As a reminder, the government stimulus began to be disbursed to taxpayers in the third week, so we're planning our guidance with that in mind. We had a slower start last year and then saw a significant acceleration as we progressed through the quarter.

In relation to availability, there is indeed some availability, but it varies across different merchandise departments and classifications. As we navigate supply chain congestion and related issues, the situation isn't uniform across all areas of our business. However, we have managed to take advantage of the volatility in the supply chain due to our increase in packaway, which has risen significantly in recent months. We also anticipate additional opportunities from closeouts, as many vendors are still moving merchandise that isn't necessarily even in the country.

So with the inflationary backdrop getting tougher, I was hoping you could give us some perspective on how your customer has responded to the inflation in the past. And as you're planning for the spring season, how are you thinking about the share gain opportunity as consumers seek value versus the risk of a near-term pullback in spending as consumers digest some of the price hikes in Essentials categories?

We haven't dealt with this level of inflation in the U.S. for 40 years, so we lack extensive experience in predicting customer reactions. However, it seems that inflation will be a factor for some time. Generally, the consumer appears to be in good shape as we enter the year, benefiting from higher wages and savings. Nonetheless, given the current inflation rates, consumers will need to make careful spending decisions, likely prioritizing value, which could be advantageous for us.

Great, and congrats on the next quarter. So Barbara, maybe could you elaborate on the behavioral changes that you cited tied to value and convenience, when you saw this potentially accelerate, how you think the model is positioned? And then just on the profitability front, as you cited in 2023 and moving forward, operating margin improvement, help us to think about the drivers of that as we think about the return to double-digit earnings growth annually going forward?

Let me discuss how we're approaching this year by outlining the components of our expenses and then diving into our long-term model. Like many others in the U.S. economy, we are experiencing cost inflation across the business. This is particularly evident in transportation, both domestic and ocean freight markets, as well as in wages. We have a clear understanding of ocean freight costs, which we anticipate will remain high throughout 2022. For domestic freight, we don't foresee the same challenges, although we do expect fluctuations in fuel-related costs due to current geopolitical issues. With low unemployment rates, the overall labor market is quite tight, especially in warehousing, which has been highly competitive over the past year. However, we feel well-equipped to kick off the year, especially considering the wage adjustments we implemented in the latter half of 2021. Looking at our long-term model, we see a market share opportunity driven by consumers' increased focus on value and convenience, along with reduced competition from brick-and-mortar retailers. As we look ahead to 2023, we are targeting double-digit earnings per share growth. The framework remains similar to pre-pandemic levels, consisting of approximately 5% new store growth, comp sales of 3% to 4%, and EBIT margin expansion at the higher end of that range. Additionally, our stock repurchase program will contribute to the double-digit EPS growth.

Earlier today, Cole spoke to an improving traffic picture in the month of February and also noted that they've begun to see some trade down in certain categories, suggesting that the focus on value that you guys are suggesting has actually already started to begun. So I'm just curious if you've seen that thus far and how it bodes for the balance of the year.

We wouldn't comment on inter-quarter trends for us. Obviously, the latest information we can talk about is in January, what we did see during the quarter, as Omicron spiked, surged right before Christmas, we did see a falloff on traffic, but the customer with their fewer trips bought more per transaction as we progressed through the remainder of the quarter.

And the focus on value, our customer has always been focused on value. But as the world is evolving and the inflation, we actually feel we have an opportunity to gain a trade-down customer at the same time. So value has always been critical for us, and it's something the merchants are constantly watching and evaluating, especially as retails have gone up in the outside world, understanding where our price value relationship is with everything. So value is critical to us always, and it'll just be more important going forward.

Just following up on that. You had discussed last quarter some limited pricing actions in certain categories. Can you update us on the success of that and if you plan to continue to broaden that out through more of the store?

We have implemented a strategic process where our team continuously evaluates the market to understand pricing and identify potential opportunities for price increases. We initiated this last quarter, and it has carried over into this quarter. The average price per SKU saw a slight increase during this period. We have achieved successes in various areas compared to our previous standing, and we are being cautious about making adjustments based on our position in the market. We are evolving and making purchases in specific commodities where we've seen positive results. It is essential to remember that the value we offer to our customers is defined by the appropriate price difference between us and mainstream retailers. We will continue to monitor these developments and adapt accordingly.

It seems that while you were initially hesitant to discuss AUR increases, now that two quarters have passed, the global market is poised for significant price increases. Do you believe the opportunity to raise prices has improved compared to one or two quarters ago? Additionally, as you examine the store, are you beginning to notice signs of new customers that suggest a shift in purchasing behavior? In the past, during the recession, your company attracted many customers from department stores and specialty apparel shops. Are you seeing any indications of a similar trend with the new customers coming in?

Michael, first, let's discuss pricing. Over the last two quarters, we have been closely monitoring it. We have a process in place to observe the retail movements of our competitors, including all types of competition, because merchants are keeping an eye on that. Where we see opportunities to provide exceptional value to the customer, we are seizing them. If we believe we cannot offer that value at this time, we will not proceed. Additionally, it is challenging to predict where mainstream retailers might head in the future or what actions they will take, as prices can continually rise until they no longer function. Traditional retailers can fluctuate at any given moment. Therefore, we are focused on managing our way through by providing great value to the customer, increasing the average unit retail where appropriate, and ensuring we consider future performance possibilities. There are numerous variables involved, which is why we have processes in place and are taking a strategic approach. However, where we have operated strategically while continuing to offer significant value to our customers, it is proving effective. Regarding the trade-down customer, it is somewhat difficult to determine whether this is happening concerning specific product types or retailers. I wouldn’t say we've noticed anything specific indicating that we are currently attracting trade-down customers. Nonetheless, with ongoing inflation, it would be reasonable to conclude that we could potentially gain additional market share over time.

I have just a quick follow-up on the pricing question again, I'm sorry. But are you able to take prices up at dd's? I know those prices tend to be a little bit lower and the customer a little bit more sensitive. And then if you could also just talk about past this year kind of longer term, you said there's a change out there in bricks-and-mortar, fewer competitors, potentially meaning a healthier retail environment in general. So is there an opportunity for you guys to push up the food chain a little bit with some better brands and some changes to the assortment just a little bit, especially at Ross Stores?

We recognize that customers at dd's are very price sensitive and prefer lower price points. However, we are applying the same process at dd's as we are at Ross, where we are analyzing the market. Our merchants are gaining insights into customer values, especially since a significant portion of dd's competition is in the mass market, where prices have increased. We are committed to understanding this and making informed decisions. dd's has also experienced success in certain areas where they have implemented these strategies. Overall, it's an ongoing process for both companies. Regarding the assortment strategy, we are comfortable with our approach to better brands and will continue to test different brands to see how customers respond. Our goal is to provide customers with what they want. However, we are aware that brand supply can fluctuate, particularly with better brands. We are consistently looking to enhance our brand strategy and offer the best products and value to our customers. As we identify new opportunities and see positive customer responses, we will adjust our assortment accordingly.

I want to ask about the lower income consumer. Do you see any changes in purchasing patterns related to this specific customer cohort? Or any color on trends at Ross versus dd's?

I wouldn't highlight any specific differences between Ross and dd. dd's performance has been consistent, and both have actually benefited from government stimulus earlier in the year while maintaining similar levels. In terms of changes, there are numerous factors affecting consumer behavior, such as COVID, inflation, and other influences, making it challenging to specifically isolate their behavior in relation to income.

As you think about the expanded opportunity for new store openings at both businesses, any adjustments in the size that you're making, how are you thinking about the regions where you're going to and expanding into and any framework this past fourth quarter of what you saw by region and how it was different by brand?

In the fourth quarter, we observed that the top-performing regions were the Southeast and the Midwest. Our largest markets were California, Florida, and Texas, with Texas outperforming the chain average, while California and Florida were slightly lower. Regarding our long-term store potential, we remain confident based on our annual research into store viability. Key factors include the consumers' emphasis on value and convenience, the closures of brick-and-mortar retail, and the shifts in traffic patterns due to changing customer behavior after COVID. Additionally, our strategy of clustering stores in high-density, high-volume areas has proven effective in smaller markets. We are also pleased to see a favorable growth trend within our targeted demographics, which supports our increased store count potential to 3,600 locations.

It's about the long-term growth strategy that you're presenting today, which is more of a philosophical discussion. Why is now the right moment to unveil this long-term growth strategy, especially as we enter our third year where the comparisons may not hold up? What gives you the assurance that you can achieve sustainable comparable growth? What kind of economic conditions do you need to meet your objectives?

I would say, first, that due to our customers' ongoing emphasis on value and convenience, we are well-positioned in the retail sector and see a significant opportunity to expand our market share. Although 2022 presents challenges in forecasting, we believe we can increase our market share and have the necessary strategies to achieve this.

If I could get a quick follow-up, will the store growth of about 5% lead to an increase in your CapEx in the coming years to around 4% or 5% of sales compared to the historical rate of 3% to 3.5%?

There are a couple of factors that influence capital expenditures. One of the most significant is the growth of new stores. However, this can fluctuate due to the capital associated with our distribution centers. Last year, we opened a new distribution center that will begin operations early this year, which may result in some variability. Looking ahead, I believe expenditures will remain around these levels, possibly increasing slightly in the future due to the growth in distribution center capacity.

Freight inflation and wage inflation isn't the only cost inflation out there. Product costs are higher. What's the outlook for merchandise margin this year and long term?

Yes. John, I'll jump in on that. Consistent with the prior quarters and 2021, merchandise margin was strong. Without ocean freight, it improved every quarter versus 2019. So while we expect ocean freight costs to remain elevated through 2022, we're going to anniversary that initial spike in ocean freight costs in the fall. So as we look forward into 2022, again, without the impact of ocean freight, we feel like it's healthy and will continue to be strong and grow in 2022, obviously, dependent on sales and inventory turns but feel strong about that.

Got it. Just maybe one quick follow-up. Where are we in the wage inflation cycle at Ross stores, you seem to imply that you've taken wages up both in stores and DCs. We've heard quite a bit from some of your big-box competitors out there about where they're taking wages. Where are we in the wage inflation cycle here? Do you feel comfortable where you are now in both DCs and stores?

Yes, as we look toward the end of the year, we are optimistic about the changes implemented last year. Our strategy involves assessing wages based on individual markets instead of applying a universal approach. It's important to note that there are mandatory wage increases, including those in California and other significant states. We are adhering to these regulations while also making decisions tailored to each market to ensure we attract excellent talent throughout the organization.

Just on freight, I think you gave on a LLY basis, it was a 100 basis point headwind in Q4. Can you just say what that was year-over-year, just to give some context. And then if there's any way you could explain what's embedded. I think you said the cost should get much better as you move through next fiscal year. But what is the year-over-year headwind that you're currently anticipating, whether it's first half, full year? Anything that would be helpful would be great.

Ike, we wouldn't give specifics on the deleverage. We usually would do that after the fact. But as I explained the back half of last year is when we started seeing significant increases in ocean freight as lead times extended, and we had to pay more in the spot rate market, so we're up against that. We'll be up against that next year, so it will be less of a headwind this year. Overall, we expect, though, that ocean freights will stay elevated all the way through the year and perhaps a bit higher, but the vast headwind will be in the first half of the year versus the second half of the year, if that makes sense.

Thank you for joining us today and for your interest in Ross Stores.