Ross Stores Inc (ROST) — Q1 2022 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 Connie Kao, Group Vice President, Investor Relations. We'll begin our call today with a review of our first quarter 2022 performance, followed by our outlook for the second quarter and fiscal year. Afterwards, we'll be happy to respond to any questions you may have. As noted in today's press release, we are disappointed with our lower-than-expected first quarter results. We knew 2022 would be a difficult year to predict, especially the first half when we were facing last year's record levels of government stimulus and significant customer pent-up demand as COVID restrictions eased. The external environment has also proven extremely challenging as the Russia-Ukraine conflict has exacerbated inflationary pressures on the consumer not seen in 40 years. As a result of these factors, our first quarter results underperformed our expectations. Total sales for the first quarter were $4.3 billion with comparable store sales down 7% on top of a robust 13% gain in the first quarter of 2021 that were versus 2019. Earnings per share for the 13 weeks ended April 30, 2022, were $0.97 on net income of $338 million. The quarter includes an approximate benefit of $0.06 per share from the favorable timing of expenses that are expected to reverse in subsequent quarters. These results compared to $1.34 per share on net earnings of $476 million for the 13 weeks ended May 1, 2021. Men's was the strongest merchandise area during the quarter, while Florida was the top-performing region. dd's DISCOUNTS performance in the first quarter trailed that of Ross, as the significant benefit of last year's stimulus and escalating inflationary pressures had a larger impact on lower income households. At quarter end, total consolidated inventories were up 57% versus the same period in 2021, mainly from higher packaway inventory. Packaway merchandise represented 43% of total inventories versus 34% last year when we used a substantial amount of packaway to meet robust consumer demand. Additionally, supply chain congestion eased somewhat during the first quarter, resulting in the early receipt of merchandise that we stored in packaway and will flow to stores later in the year. Average store inventories during the quarter were up, though we still operated with significantly less inventory in store than we did pre-pandemic. Turning to store growth. Our 2022 expansion program is on schedule with the addition of 22 new Ross and 8 dd's DISCOUNT locations in the first quarter. We remain on track to open a total of approximately 100 locations this year, comprised of about 75 Ross and 25 dd's. As usual, these numbers do not reflect our plans to close or relocate about 10 stores.

Thank you, Barbara. As previously mentioned, our comparable store sales were down 7% for the quarter as average basket growth was more than offset by the decline in transactions versus the prior year. First quarter operating margin of 10.8% was down from 14.2% in 2021, mainly due to the deleveraging effect of the same-store sales decline, along with ongoing cost pressures from higher freight and wages that began to escalate in the second half of 2021. As Barbara commented earlier, the quarter benefited from the favorable timing of expenses, most of which were in gross margin. Cost of goods sold in the first quarter increased by 295 basis points due to a combination of factors. Merchandise margin declined 170 basis points, primarily due to higher ocean freight costs. Domestic freight rose 80 basis points while occupancy delevered 40 basis points on the same-store sales decline. Distribution costs increased 25 basis points, mainly due to wage actions taken last year. These unfavorable items were partially offset by buying expenses that improved by 20 basis points. SG&A for the period rose 50 basis points due to higher wages and the deleveraging effect of lower comparable sales. During the first quarter, we repurchased 2.5 million shares of common stock for an aggregate cost of $240 million. We remain on track to buy back a total of $950 million in stock for the year. Now let's discuss our outlook for the remainder of 2022. As Barbara noted in today's press release, given our first quarter results and today's increasingly uncertain macroeconomic and geopolitical environment, we believe it is prudent to adopt a more conservative outlook for the balance of the year. We are now forecasting comparable sales for the 13 weeks ending July 30, 2022, to decrease 4% to 6% on top of a very strong 15% gain in the prior year period. Second quarter earnings per share are projected to be $0.99 to $1.07 versus $1.39 last year. Our guidance assumptions for the second quarter of 2022 include the following: Total sales are forecast to decline 1% to 4% versus the prior year. We plan to open 29 locations in the second quarter, including 21 Ross and 8 dd's DISCOUNTS locations. Operating margin for the second quarter is planned to be in the 10.4% to 10.8% range, down from 2021 due to deleveraging on lower same-store sales and ongoing expense headwinds that are expected to continue through the first half of 2022. Net interest expense is expected to be approximately $15 million. The tax rate is projected to be about 25%, and diluted shares outstanding are expected to be approximately 348 million. For the full year, we are now planning comparable store sales to decline 2% to 4% and earnings per share in the range of $4.34 to $4.58. As Barbara mentioned, this reflects our continued expectation for sales and profitability to improve as we move through the balance of the year.

Thank you, Adam. Looking ahead, while the landscape in early 2022 has been tougher than expected and the year may prove to be more difficult than initially anticipated, we remain confident in our ability to successfully navigate through this period. We have shown in the past that our value-focused business model has served us well in both healthy and more uncertain external climates and believe the current challenging conditions will be no different. Despite the slower-than-expected start to 2022, we operate in an attractive sector of retailing. Our mission continues to be delivering the best bargains possible to leverage our favorable market position. As demonstrated by our long successful track record, we believe our steadfast focus on the execution of this core strategy will be the key driver of our success. At this point, we'd like to open up the call and respond to any questions you may have.

Barbara, I wanted to ask about product and merchandise execution. Could you just comment on how you feel the team is executing in merchandising? And how did merchandise margin perform here in the quarter, if you exclude, let's say, inbound freight and domestic transportation costs? Are there any pockets of inventory where you wish you had a little bit more and how in aggregate are you feeling about your overall inventory position?

And Barbara, this is Adam. I can jump in on the merchandise margin question and then throw it back to you. So Kimberly, merchandise margin, as stated in the comments, has dropped 170 basis points versus last year. But we would have been flat versus last year's significant gain without the impact of ocean freight.

In terms of inventory, there is currently a lot of availability in the market across different categories, including home and apparel. I wouldn't characterize any of our inventory areas as problematic. Regarding our product execution, I believe we haven't performed to our full potential. We are currently analyzing our business and think we can enhance our product assortments and overall execution. At this stage, our focus is on taking different actions to improve some of our assortments.

Obviously, a very tough environment out there, especially for lower-income consumers. We've heard from other retailers that the initial shock of inflation following Russia and Ukraine led to a pause. Curious if you've seen any notable change in trend, a positive change in trend as you move through April and into May. And then bigger picture, Ross has navigated weaker economic environments in the past, benefited from the trade down to value. Just how do you view the potential for that as the year unfolds?

Mark, it's Michael Hartshorn. During the quarter, we had a strong start, but sales fell short for the rest of the period. Importantly, we faced the anniversary of last year's government stimulus and the customer demand that built up. Additionally, we did not experience the Easter boost we had anticipated. We won't provide details on inter-quarter trends at this moment. Regarding the trade-down customer, it's difficult to gauge. With rising fuel and food prices, lower-income customers are facing tighter discretionary spending. We noticed that customers at both chains reduced their spending in the first quarter.

I wanted to follow up on your comment, Barbara, about sales and profitability improving as the year progresses. Can you provide some context on what makes you confident, particularly regarding the top line, that things will improve as the year continues?

Lorraine, regarding the top line, the guidance reflects a consistent pace. In the fourth quarter, we recognize an opportunity because we were affected by Omicron and faced supply chain issues that caused us to lose business in the fourth quarter last year. Concerning profitability, as we mentioned at the start of the year, we implemented wage increases in the latter half of 2021, which coincided with rising freight costs. The guidance takes into account these increases from last year. Essentially, the adjustments we made to our guidance are primarily related to sales, and we have not altered our expense projections. Initially, we felt confident about our understanding of freight, ocean freight, and wages. The only slight change has been in fuel costs, but we have managed to compensate for this with other expenses in the business. Therefore, the revised guidance is fundamentally about sales performance.

And Lorraine, in terms of the assortment, what happened last year is that merchandise slid, as I'm sure it did for all retailers. Different product categories created real gaps in the assortment. So as you get into fall and the inventories catch up with where those gaps were gives you the confidence in certain businesses that the performance should be better.

So Barbara, on the magnitude of the comp slowdown as the quarter progressed, I guess, were there any notable changes by category or specific geographical call-outs as you dissect the first quarter? And then just looking back, if we take maybe a broader picture thought process, are there any time frames that you'd compare the magnitude of this sharp slowdown? How many quarters or how long did it take for your model to respond? Just kind of thinking about the duration in the past, and then the subsequent improvement that you're baking in as the year progresses?

In terms of a slowdown, Michael, from one quarter to another, I can't really think of a period of time were we baked in that other than in 2016, where we had difficulty in the ladies business, where we had a slowdown. Yes. I mean, Matthew, we knew there was going to be a slowdown, at least on a comp level with all the government stimulus that came out last year. So we had actually planned that in the business and also with the customer pent-up demand as COVID restrictions ease. So even in our initial guidance, the low end of the range was a minus 4, so we missed that by about 3 points. In terms of where in the business has slowed down, it was pretty broad-based. We did see pockets of opportunity. If you look at our larger markets, Texas and Florida outperformed. We had expected, as the border opened up, that we'd see improvement there. We, in fact, did in Florida as tourism and travel started to increase. We had planned increases there, and we saw improvement. And then in terms of the assortment, apparel outperformed home. We were up against very large comps in home in Q1. And so that's really where we saw a large difference in performance.

So I guess as we look at the quarter on paper, this looks pretty far from where we were on the narrative in early April. I think there's been a pretty consistent narrative that you felt good on inventory. And I think you felt like it came into spring with the right mix of goods for the categories. The consumer is clearly drawing the line between wanting back-office apparel dresses for women, those kinds of things. So it does sound like demand was the issue. I think you did, however, talk about, in the initial guidance, an acceleration through the year. And I think at the time, one of the inputs was, by 2Q last year, once stimulus kind of cleaned out some of the inventory, you were in chase mode on some real meat and potatoes items that were just stocked out. And I think that fueled a lot of your optimism baked into the acceleration through the year. So it seems like the demand line has changed quite a bit here and that just having inventory may not be sufficient at this point. But how do you true that up and bring that forward and say, 'Look, we were missing some categories a year ago in 2Q versus the expectation for sales to continue to be very, very slow here in the second quarter?'

Michael, I would just say overall, I mean, it serves us well to be given our underperformance in Q1 to be cautious with the rest of the year. And that's why you saw us bring down the guidance. And that's true from buying inventory to running the company with lower expenses. So we'll see how it plays out. I mean it's very uncertain out there. The inflationary environment was much more than we expected when we entered the year, and we're going to put ourselves in a position to chase business and to chase trends, and we think that will allow us to maximize our potential in this environment.

And as we dig into the opportunities of the businesses that we did miss and that we didn't have last year, that would be part of what we're looking at to improve the business. So making the shift in your example into more dress versus casual and making the appropriate move. So we're digging into that piece now.

Okay. Can I follow up on that? Is it accurate to say that you may have adjusted the AUR strategy a bit based on some of the feedback we've heard in the industry? It seems like there's now a greater emphasis on value compared to what you were originally considering for the consumer.

Sure. The AUR strategy, we strategically increased prices. So we didn't do it just straight across the board. So what we really did was make sure that there was appropriate price separation from traditional retailers. And so we monitor that very, very closely. And so the merchants can see on the term line every single week whether something is working or not. And so that piece will continue to do in both companies really with a high focus on value, right? So that a slightly higher AUR might be a very strong value based on what's going on in the rest of the world. So I think the value equation, to your point, is really what our customer looks for and comes to expect from us. And so we are highly focused on the value equation. But that doesn't mean that potentially an AUR could be higher. So they're not mutually exclusive. It could be both ways. You really have to know where and what.

It seems like the buying environment is about to turn from just okay to potentially extremely good given where retail inventory levels are going to exit the first quarter, particularly in home. So I'm curious how quickly the merchant buying teams can take advantage of this? And have you baked any of that into the guide for 2Q and beyond?

Well, the merchants can take advantage of the closeout opportunities as they become available. And there are closeouts in home, and that's more unusual than it is in apparel. Supply lines right now are very broad-based because of all the things that you know. Goods coming in early. People bringing in fall early. So it's kind of all collided at the same time into the marketplace. But the merchants can take advantage of that as quickly as possible, if it's the right merchandise and right product. So there's nothing in their way to keep them from doing that.

Regarding your question on the guidance, we have not factored in any potential upside into our projections.

I have two quick questions. Regarding the merchandise margin this quarter, with ocean freight being fully accounted for at 170, based on the contracts and the visibility you have, what can you tell us about the overall headwind as we move into Q2 and beyond? In addition, concerning Michael's question on AUR, can you provide insights on your inventory? It seems quite heavy, and sometimes it’s difficult to interpret the situation. Are you comfortable with your current inventory position? Do you anticipate needing to clear more products in Q2? I'm trying to gauge your comfort level regarding inventory right now.

I'll address your question about inventory first. Overall, the growth in inventories was primarily due to packaway. We ended the period with 43% of our total inventories in packaway, compared to 34% last year. Last year, we used a significant amount of that packaway to meet the demand we experienced at the end of the first quarter when stimulus payments were issued. The 34% level was lower than our historical averages. Another factor to consider is supply chain congestion. As we began this year, we anticipated longer lead times based on fourth-quarter trends. Consequently, for our businesses that primarily import, particularly in home goods, the supply chain improved somewhat in the first quarter, allowing us to receive goods intended for the second quarter early, which we stored in packaway to be released later in the year. In terms of in-store inventories, we had more than last year, but it's important to note that they were lower than we expected due to unexpectedly high demand, though they remain below pre-pandemic levels. Overall, we are satisfied with our inventory levels.

Yes. Regarding ocean freight, rates will remain elevated for the rest of 2022. However, as we reach the anniversary of the spike in the second half of last year, they are still high but have improved as the year progresses. On the domestic freight side, as Michael mentioned, fuel costs are higher than we initially expected at the start of the year, but we have accounted for that in our guidance. By the second half, we do not expect any pressure on domestic freight.

In terms of packaway, we're very comfortable with the content of packaway also.

A few quick ones, if possible. Do you know inventory growth in units versus dollars? And then what percent of the freight costs generally are ocean versus domestic?

We wouldn't give you the unit growth. That's not something we disclose.

Okay. And freight costs, just ocean versus domestic in general?

Can you repeat the question?

When you think about your total freight costs, just roughly what is the ocean versus domestic breakdown? So what percentage of your freight costs tend to be ocean versus domestic?

We don't disclose that externally.

Okay. I'll try one last question then. You mentioned deleverage. What do you expect for SG&A dollar growth to look like for the year, based on the comments you made?

Could you repeat that question?

So, regarding the full year guidance, how are you anticipating SG&A dollar growth?

I don't know. Can we call you after the call to get specific modeling questions for you?

Sounds good.

Barbara, I wanted to explore the comment about redirecting or reallocating some of the penetration. What was home penetration during the quarter compared to ladies apparel? I'm assuming that the apparel segment performed better. Additionally, can you provide insight on store traffic trends throughout the quarter? It would be great if you could help us with both of these points.

In terms of overall home apparel, I think Barbara mentioned earlier that apparel outperformed home, although home was up against very strong comps last year. Adrienne, we also talked a little bit about the trend, and that was similar for traffic in that we had a strong start to the year, so year-over-year growth. And then that dropped in later in the quarter as we started to anniversary the stimulus and also customer pent-up demand.

Home penetration constitutes about 25% of the company’s total sales, which is comparable to pre-pandemic levels. Regarding packaway, the figure was around 43% at the end of this quarter. Some of this reflects the early receipts in home goods. Were you able to take advantage of any challenges during the transition to spring? Although you don't have significant exposure to the Northeast, could you pick up some of those goods from Northeast retailers? We've seen this benefit you in the past, where the short really helps as you repurpose it in the second quarter. Is that a potential opportunity? I believe this situation is not solely due to Northeast retailers. A significant amount of spring merchandise entered the country simultaneously with both last fall's and early spring shipments. So while some impact may originate from Northeast retailers, much of it is attributable to the overall supply chain improvements that occurred concurrently. We have successfully acquired the spring products we need, and indeed, we will utilize some spring items from the first quarter into the second quarter.

One clarification. I think someone on the call mentioned you did not see the lift around Easter that you normally do. And I was curious if that was related to traffic or assortment? I'm just trying to think it through to other holidays that are coming up and the more traditional cadence of retail business getting back to where it was. And then if you could just talk a little bit about any excess you have going into the second quarter? Will it be liquidated in the second quarter? Or is it current enough that it doesn't have to be marked down? And is this contemplated in the operating margin guidance?

Marni, we ended the store inventory at the levels we targeted, so there won't be any liquidation beyond the first quarter. Regarding Easter, as I mentioned earlier, our performance fell short of expectations. Generally, when Easter occurs later, we experience less weather impact, and we did not meet our plans in that regard.

I'm curious, do you think the lower traffic was the reason? Or was it related to the assortments? Do you believe it was primarily due to general traffic patterns or the assortments you had for Easter?

What you would define as the Easter assortments, Marni, dresses, dress shoes, children's dresses, those just were fine.

So that was fine. So you had the lift for that, but the overall traffic lift, as people kind of have a little bit of time off or holidays coming up, that you didn't see?

I would say, overall, the traffic is probably a large function of the consumer being squeezed with inflation.

I have two, please. So I'm trying to square the model of your FY guide versus the Q2 guide, implies that you're modeling about flat comps in the second half of the year. And I'm trying to square that with your view of you're lapping assortment gaps last year, so you should be able to pick up more in the back half of the year. So how does that square with the view of flat comps? And then my next question is around packaway. So you picked up a lot of packaway in Q4. When does that start to flow through? Is that fall/winter assortment that we should start to see that margin benefit from that flowing through in the second half?

On the back half, that it does include our easiest compare in the fourth quarter. So fourth quarter would be the stronger comp. On packaway, on average, packaway, we hold it for about 4 months. So that's the way you should think about the timing on when we typically flow goods.

But just to follow up on the packaway. If you pick up the packaway in Q4, most of that will have already flowed through, correct?

It depends on the product. For the packaway that we acquired in the fourth quarter, if we consider outerwear, it is seasonal. This packaway would typically be shipped from the vendor at the end of December and released in the fall season. However, other types of products like denim, fleece, knits, or certain home items are seasonless and can be available throughout the year. These products can flow in either the first or second quarter. Many packaway items are indeed seasonless, so it really depends on the specific product.

Last quarter, we had talked about taking price. Where are we in that journey given the slowdown? Is that being adjusted at all? What are you seeing? And how does it differ for dd's versus the Ross brand?

Sure. So as we've talked about before, we started to increase some of our AURs. Keeping in mind that it has to be the appropriate value separation from traditional retailers and in both companies. And we're strategically doing it. It's not just straight across the board and obviously examining that very closely, does it make sense or not. And you can do that simply by how quickly the goods turn and the markdown rate. So the merchants are managing that every week while they're going through their selling. And then we're reviewing it, obviously, at a higher level to make sure that, that hasn't been an issue. But in both companies and particularly in dd's where the customer is very price sensitive, we really look at that at a pretty low level.

Got it. And then just the health of your consumer, what are you seeing there? And how do you define the household income of dd's and Ross customers?

Sure. Our overall customer base is very diverse in terms of age, ethnicity, and income. On average, Ross customers have household incomes between $60,000 and $65,000, while dd's customers fall below that, in the $40,000 to $45,000 range. However, I would say that the financial health of our customers is being affected. With rising food and fuel prices due to inflation, they have less to allocate for discretionary purchases.

And then just lastly, as you think about the real estate portfolio, so then keep maintaining the same level of new store openings. Is there anything that would make you adjust your rate of new store openings? Or given that's a glide path for the future, no adjustment in the strong balance sheet that you have? How do you think of that real estate portfolio?

Yes. At this point, Dana, we wouldn't change our glide path. We're planning to open 100 this year, and we will execute to that. And then we'll revisit our long-term plans. But we think there's market share available. We think there's market share opportunities. We think value will become increasingly important for the customer as it has over the last number of years. And we think we have a great opportunity ahead of us. So we would continue with our store opening plan.

I'm wondering if weather had an impact on your comp this quarter. The strength of Florida would seem to point to that, but the comment that the comp decelerated as the quarter progressed sort of fights against that theory.

Laura, the weather did not have a material impact on the business in the quarter.

How are your more mature markets, like some of the California markets holding up relative to the whole?

California performed similarly to the chain, as did our larger markets, Texas and Florida.

I was wondering if you could comment on the divergence and performance between Ross stores and the dd's DISCOUNTS? Curious one on one began slowing down earlier than the other? And then maybe about a question on the second half. I'm looking into the numbers, it implies roughly second half of the year flat comp sales, but I think it also implies double-digit EPS growth. So I'm wondering like what are the puts and takes there to drive the EPS growth in the second half of the year?

dd's performed lower than Ross, but they were facing tougher comparisons due to stronger gains last year, particularly from government stimulus that greatly influenced that consumer segment. Last year’s stimulus, coupled with their income levels, also made them more susceptible to inflation compared to Ross customers. Adam Orvos mentioned that later in the year, we can expect profitability improvement despite flat sales. We will be comparing against the previous significant increases in wages and domestic and ocean freight costs, which will provide the boost you see reflected in our model.

I believe in the prepared remarks, you talked about supply chain congestion easing somewhat. I was wondering if you could provide some incremental details about what you meant by that, what you witnessed in the quarter and then perhaps maybe what you're expecting going forward.

Sure. It's best to start from last year. So last year, the lead times degraded as we move through the year, so they got longer. So we planned the year based on what we saw in the fourth quarter. And what we saw in the first quarter is it did ease somewhat, which meant we received goods early. Expectations for going forward, I think, will be highly dependent on how China comes back from their shutdown. So we're watching that very closely. We're going to be very cautious with our lead times, but I think it's going to be dependent on whether when they open back up and the timing of when it opens back up, what type of congestion that causes.

I apologize if this has already been covered, but when you mentioned execution issues, are they primarily related to not having enough better-selling products and having too many slower-selling ones? Or are there other factors you would highlight? Additionally, how would you differentiate the sales shortfall between execution challenges and a slowdown in consumer demand?

Yes, we believe we can improve. In this inflationary environment, which is unprecedented for us, we understand that we can provide our customers with better deals, and we will strive to do that. Therefore, it's challenging to distinguish between execution issues and the effects of inflation on consumer behavior.

In terms of the nature of the missed execution, can you clarify whether it was entirely related to product availability, how much of the better-selling product was in stock, or if there were also pricing issues involved? It would be helpful to understand this better.

I think it returns to what Michael mentioned. It’s not that we had one significant mistake or one major business that is truly underperforming. We believe that our execution has not reached the standard we are capable of. This could be something straightforward like having purchased more products for careers instead of casual wear, making small adjustments in penetration rates, or improving delivery of certain items. Our operations are just not as sharp as they typically are. If the main inquiry is whether there are significant assortment issues in specific areas, there are none. We need to improve our execution to align with our true capabilities, as we have consistently demonstrated in the past. That’s the priority for us as an organization.

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