Ross Stores Inc (ROST) — Q3 2022 Earnings Call Transcript

Good afternoon. Joining me on our call today are Michael Hartshorn, Group President, 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 third quarter performance, followed by an update on our outlook for the fourth quarter and fiscal year. Afterwards, we'll be happy to respond to any questions you may have. As noted in today's press release, third quarter results were above our expectations as we delivered stronger values throughout our stores. Operating margin for the period was 9.8% versus 11.4% last year, reflecting the deleveraging effect from the comparable sales decline as well as pressure from higher markdowns and unfavorable timing of packaway-related costs. Earnings per share for the 13 weeks ended October 29, 2022, were $1 on net income of $342 million. This compares to $1.09 per share or net earnings of $385 million for the 13 weeks ended October 30, 2021. Total sales for the quarter were $4.6 billion, in line with the prior year, with comparable sales down 3% on top of a robust 14% gain in the third quarter of 2021. For the first 9 months, earnings per share were $3.08 on net earnings of $1.1 billion compared to $3.82 per share on net income of $1.4 billion for the same period in 2021. Sales for the year-to-date period totaled $13.5 billion with comparable store sales down 5% versus a strong 14% increase last year. For the third quarter at Ross, shoes was the best-performing business, while Florida and Texas were the top-performing regions as they were bolstered by the outperformance of border and tourist locations. At dd's DISCOUNTS, sales trends improved versus the first half, but continued to trail Ross' results due to ongoing inflationary pressures that are having a larger impact on dd's lower-income customers. Inventory levels moderated significantly from the first half of the year, with total consolidated inventories at the end of the quarter up 12% compared to last year. Average store inventories during the quarter were up 4% versus 2021 and down compared to pre-pandemic levels. Packaway merchandise represented 41% of the total compared to 31% last year when we used packaway merchandise to fuel robust sales gains. Turning to store growth. We completed our expansion program for 2022 with the addition of 28 new Ross and 12 dd's DISCOUNTS in the third quarter. For the year, we added a total of 99 locations comprised of 71 Ross and 28 dd's DISCOUNTS. We now expect to end the year with 1,693 Ross stores and 322 dd's DISCOUNTS locations for a net increase of 92 stores. Now Adam will provide further details on our third quarter results and fourth quarter guidance.

Thank you, Barbara. As previously stated, comparable store sales were down 3% in the quarter. Although traffic improved from the second quarter, it still declined versus the prior year. Partially offsetting these declines was a higher average basket size. Operating margin of 9.8% for the third quarter was down 160 basis points from last year. Cost of goods sold grew by 230 basis points in the quarter. Merchandise margin declined 165 basis points, primarily due to higher markdowns. Distribution costs were up 140 basis points, mainly due to unfavorable timing of packaway-related costs and deleverage from our new distribution center, while occupancy deleveraged by 20 basis points. These higher expenses were partially offset by a 75 basis point decrease in buying costs, mainly from lower incentives. Lastly, pressure from domestic freight expenses eased in the third quarter and improved 20 basis points as we anniversaried the freight headwinds that began in the second half of last year. SG&A for the period improved by 70 basis points as deleverage from the negative comparable sales was more than offset by lower incentives. During the third quarter, we repurchased 2.8 million shares of common stock for an aggregate cost of $244 million. We remain on track to buy back a total of $950 million in stock for the year. Now let's discuss our fourth quarter guidance. We continue to expect a very promotional holiday selling season and ongoing inflationary headwinds to pressure our low- to moderate-income customers. That said, we face our easiest sales and earnings comparisons in the fourth quarter and are raising our guidance, given our third quarter sales momentum and improved holiday assortments. For the 13 weeks ending January 28, 2023, we now expect comparable store sales to be flat to down 2% on top of a 9% gain in the prior year. As a result, earnings per share are forecasted to be in the range of $1.13 to $1.26. The operating statement assumptions that support our fourth quarter guidance include the following. Total sales are projected to be flat to up 3%. We expect operating margin to be in the range of 9.7% to 10.5% versus 9.8% last year. This mainly reflects the anniversary of significant cost pressures from ocean freight and lower incentives, partially offset by the deleveraging effect from lower same-store sales, unfavorable timing of packaway-related costs, and higher markdowns. Net interest income is estimated to be about $14 million. Our tax rate is expected to be approximately 23%. And weighted average diluted shares outstanding are projected to be about 342 million. Based on our year-to-date results and fourth quarter guidance, earnings per share for fiscal 2022 are now projected to be in the range of $4.21 to $4.34 compared to $4.87 last year. Now I'll turn the call back to Barbara for closing comments.

Thank you, Adam. Despite the many challenges over the last few years, coupled with today's uncertain macroeconomic and geopolitical environment, we remain optimistic about our future growth prospects. Our top priority is and always will be delivering fresh and exciting named brand merchandise at compelling discounts every day in our growing store base of over 2,000 locations. With consumers' heightened focus on value and convenience, this bodes well for our ability to expand our market share and profitability in the future. At this point, we'd like to open up the call and respond to any questions you may have.

Congrats on a nice quarter. It's great to see the return to beat and raise. So Barbara, maybe relative to your internal expectations, what did you see from traffic? Or maybe could you speak to the cadence of comp trends as the third quarter progressed? And then could you just elaborate on the improved holiday assortments that you cited in the release?

On the traffic trends, this is Michael Hartshorn. As we mentioned in the prepared comments, with the comp down 3%, traffic did improve for the quarter, but it still declined compared to the previous year. The decline in traffic was offset by a higher average basket, which was driven by increased average unit retails, though units per transaction remained flat. The rise in the average basket was more than offset by a decrease in the number of transactions. As we moved through the quarter, we observed improved trends when compared to 2019.

Great. And then just a follow-up. Maybe relative to the third quarter, could you just elaborate on maybe the macro or the competitive landscape assumptions that you embedded in your fourth quarter comp guide? It does embed a moderation? Is that prudence? Is it something that you've seen? Or are you embedding more competitive backdrop and maybe a deterioration in the macro in the fourth quarter?

I would say from our perspective, the macroeconomic environment remains uncertain, but we believe the holiday period will be very promotional, which we've factored into our guidance. Additionally, it's important to note that last year, sales at the end of the quarter declined, making it our easiest quarterly comparison. This decline happened for two main reasons: a spike in Omicron cases and ongoing supply chain challenges that affected us and other retailers.

Great color. Congrats again. Sorry. Go ahead, Barbara.

Okay. The holiday assortment, so look, we believe our holiday assortment this year, we really have an improved offering of both branded bargains based off of availability in the marketplace and also particularly our gift giving, because of the imbalances we had from the supply chain congestion, as Michael just alluded to. So we feel between the two of those, we'd be able to offer great brands, strong values, and a broader assortment.

Great. Just as it relates to the updated guidance, perhaps could you kind of talk about what the key swing factors are there that could drive you either to the higher or the lower end of that new range?

Yes, sure. Alex, this is Adam. So given our guidance of flat to minus 2% comps, we'll have some deleverage impact from sales. Markdowns will be higher than last year in the fourth quarter, but not as impactful as in the third quarter. Domestic freight, we see as slightly neutral, seeing some benefit in rate, but offset by still elevated fuel prices. Ocean freight will probably be the most tangible tailwind for us. As you remember, last year, we were getting into the period where rates were escalating significantly, demand was high. So that will be a tailwind for us. And then given our outperformance last year and our underperformance this year, incentive costs will be lower in Q4 versus last year. And then finally, depending on how the end of the year plays out, we'll likely see some pressure from packaway timing in fourth quarter also.

Great. That's super helpful. Maybe could I just follow up on your inventory levels? I think you said they were up low double digits year-over-year exiting the quarter, which seems like a pretty lean level. So maybe could you tell us, do you feel like you have enough heading into the fourth quarter? Or how are you feeling about the levels and then just the broader assortment?

Overall, we feel really good about where we are at the end of the third quarter. As we said in the prepared remarks, we ended up about 12%, which was a big improvement from the second quarter when we were up 55%. And the increase over the last year is really packaway inventory. So we were at 41% versus 31% last year. And last year was relatively low versus our historical levels because we used a substantial amount of our packaway to chase sales that were well above our plan.

What do you view as the key drivers to the improving comp trends you saw this quarter? Are you seeing evidence that the trade-down is now occurring? Do you think this is a reflection of the average unit retail strategy you outlined last quarter? Just if you could expand on your overall assessments there, that would be great.

Sure. From the second quarter to the third quarter, from an assortment perspective, we went in and reset our values and got them to where we believe they need to be in this very promotional environment. So we rightsized our values through some markdowns in some places. And in some places, we rightsized some of our inventory as we were watching shifts in the business. And the other big shift is apparel and home for us in the quarter performed relatively the same, but our shoe business, which was our best performing business, was really fueled by strong values on branded products and availability in the market.

And in terms of the trade-down customer, with so many moving parts in the economy, it's difficult to parse out the individual drivers of the improvement. We have not seen a material shift in spending trends across different income demographics, but delivering better bargains to our consumer likely played the most significant role as it typically does.

I was just hoping you could square a couple of comments for us. You talked about resetting values and really focusing on the sharp price points, and your average unit retail was up. So can you talk about the drivers of average unit retail in the quarter and then your views on the pricing strategy on a go-forward basis?

Sure. Lorraine, value and price are distinct concepts. Merchants are continuously evaluating pricing and engaging in competitive shopping. In certain areas where we identified that our average unit retail was excessively high, we implemented markdowns. However, in other regions, influenced by assortments and market opportunities, the average unit retail could be higher, yet the perceived value is different. Additionally, there's a shift in the business mix to consider. For instance, our shoe business has performed well, and shoes generally have a significantly higher average unit retail. There are various factors at play. Overall, given the highly promotional environment we are currently in, merchants will be actively monitoring where values are changing and adapting accordingly. Regarding the average unit retail, it can vary based on mix and brand, so there are many factors involved.

You called out Florida and Texas as being strong regions, but you didn't call out California, which is a little bit surprising, given the checks that were sent out in the month of October. So I just wonder if you could just give us a little bit more color on geographic performance in the quarter.

Yes. This is Adam, Chuck. Yes, Florida and Texas clearly outperformed for us. We're seeing the benefit in border locations. We're seeing the benefit in tourism locations. And those were clearly the outperformers. On the flip side, California underperformed in the quarter.

And on California, the checks didn't come out till the end of the quarter, so it didn't have a material impact on Q3. In California, fuel prices have remained significantly more elevated than the rest of the country. That is, we believe, squeezing the lower- to moderate-income customer.

Curious on what's going on from a shrink perspective. We've had a couple of companies call out, I think, a drag from shrink. I think you guys usually do a physical count in Q3. So curious what you're seeing on that front. And then also just on inventory. Typically, third quarter inventory is a few hundred million bucks above Q2. Now that's a few hundred million below. So I'm just kind of curious about what your thinking is in terms of quantity and quality and how you're thinking about inventory levels relative to sales going forward.

Well, on physical inventory, we did take a physical inventory during the third quarter, and it was slightly higher than last year. And then on inventory levels in Q2, we believe we had too much inventory, which is why it's down versus the second quarter.

And then go forward, Michael?

I can't provide details about year-end, but it will depend on packaway opportunities in the marketplace.

Barbara, could you share your thoughts on the current availability of branded goods in the market and the outlook for merchandise margins in the coming quarters? How do you plan to manage that margin and whether to pass it along through the P&L or to transfer that value to consumers in order to enhance competitive opportunities in the upcoming quarters?

Sure. As you know, there's a lot of availability in the market, and it's really broad-based. And all categories, all brands, it's really broad. In terms of margin, I think the way we think about it now is the customer, our customer, especially the moderate- to low-income customer, is really focused on value. So we'll look at every brand based on how that brand sits in the world and the competitive nature of the pricing of that brand, and then we'll value it appropriately. Because that's really what the customer told us when we went in and we rightsized some of our values that we weren't as competitive as we would have been historically. So I would look at it more from the opportunity of getting great brands on the floor, putting better values out there to please the customer, and then, ultimately, to drive sales.

Great. And then just one quick follow-up. I think in the prepared remarks, you mentioned a sequential improvement at dd's. Can you talk to the drivers of that and any change that you're seeing in the behavior of your low-income customer versus maybe more of a middle- to high-income customer within your portfolio?

Sure. On dd's, the improvement from Q2 to Q3 was similar to Ross, although it continued to trail. As a reminder, the dd's customers' average household income is $40,000 to $45,000 versus $60,000 to $65,000 for Ross. So very similar improvement between Q2 and Q3.

Congrats on a great quarter. You guys are typically really conservative when it comes to the forward guidance. And others today and yesterday have spoken to a softer start to the fourth quarter. Michael, I know you won't speak specifically about intra-quarter, but you mentioned maybe that fuel is going to neutralize some of the stimulus benefit in your biggest market, macro thoughts there. But what gives you the confidence to raise in the fourth quarter, knowing what we know about the industry here, a little different than how you approached a couple of the most recent quarters? And then, I guess, Michael, you've also spoken to us in the past about what your view is of a normal algorithm for this business, what flow-through looks like on your normal sales target. Any initial thoughts on how flow-through could look next year, if we're lucky enough to be back to a conducive market for a normal comp?

Sure. On what gives us confidence on the guidance, so the multiyear stack in the Q4 is lower than what we actually achieved in the third quarter. We're confident about the assortment that we have for the holidays. And any conservatism would be based on the macroeconomic environment and what we think is going to be a very, very promotional holiday. In terms of the flow-through for next year, as you would expect, operating margin improvements will be highly dependent on sustained strong sales growth over time and how quickly some of the inflationary cost pressures subside. But I'd say, over the longer term, we think we can achieve gradual improvement in profitability. As for 2023 specifically, we're in the midst of our budgeting process for next year currently. And we'll be able to provide an update on our year-end call when we'll have a better sense of the macro economy entering the year and the opportunities we have in places like ocean and domestic freight. I would say also, keep in mind, with lower incentive costs that had benefited our profitability this year, will reset the baseline next year. And thus, incentives will be a headwind in SG&A.

Barbara, can you talk about the buying environment and how much better it has gotten perhaps in the past 60 to 90 days since last quarter? And then how long does it take from, say, a contract negotiation to being able to get that product ready and available for sale in your stores?

Sure. The buying environment has improved significantly, with more brands and classifications available. In the past 60 to 90 days, more vendors are eager to sell their merchandise, and some new suppliers we weren't previously working with are also interested in having us buy their products. There is definitely an abundance of supply available. Adrienne, could you please repeat the second part of your question?

Yes, I was wondering from the time that you actually negotiated...

It depends on how quickly a vendor can ship. If I buy the goods on Monday and the vendor can ship in a week, it probably takes about 3 to 4 weeks to receive them, depending on various factors such as where they are shipping from and which distribution center is involved. Generally, I would estimate a time frame of 3 to 4 weeks.

Okay. Fantastic. Best of luck for holiday. Congrats.

I'm interested in the contrast between what looks like more promotional department stores this year versus last and the off-price kind of effort to raise the ring a bit. How is your pricing umbrella holding up versus those mall-based stores this year?

We have been adjusting some of our values, and we plan to continue this in the fourth quarter, which is reflected in our guidance that includes some additional markdowns. The promotional calendar is quite active right now as everyone attempts to manage inventory. In some cases, the promotional activity appears as aggressive as it was in 2019, and in certain businesses, it even seems more intense. Our merchants are actively evaluating this situation. We're either purchasing based on the values we believe are necessary given the current supply or re-evaluating our existing stock to ensure we reach the right price points. Overall, the promotional environment is similar to historical trends, which is important for our merchants as they navigate purchases in the marketplace. Additionally, the perception of value is influenced by the brand and its standing in the current market.

Congratulations on a great quarter, and best of luck for the holiday. If you could provide some insight, I know you're not giving guidance yet for '23, but is it reasonable to expect that store openings will remain similar to this year? Or have there been any changes in your outlook on double digits, considering the current environment? Also, Barbara, I wanted to delve a bit more into the improved mix you mentioned for the holiday season. There seems to be an abundance of product available. Were you referring to an improved mix compared to '21, the first half of the year, the third quarter, or just that overall we have a lot of inventory and are performing well?

Marni, on the real estate front, we remain very confident in both chains and currently have no changes to our expansion plans. Certainly, we'll provide more details for '23 when we report year-end earnings.

In terms of the mix, I would say that going back to Q4, we missed several gifting opportunities last year due to supply chain issues. Specifically regarding Q4, that's a key factor. Looking at the entire year, there are simply many more brands available. It’s a combination of having access to great closeouts, better pricing, and improved brands, while also having actual gaps in our assortment. So it's both aspects at play.

Congratulations on the progress heading into the holiday season. Michael, if we examine your sales productivity through metrics like sales per square foot and sales per store, it's surpassing pre-COVID levels. While the operating margin is currently lower, there appears to be positive momentum heading into the fourth quarter and next year. You may have a clear perspective on how to return to pre-COVID operating margin levels. Where do you believe the best opportunities lie? Is it in freight, merchandise margin, or SG&A leverage? What do you think offers the simplest route back to pre-COVID profitability?

Well, sales, number one. There are structural changes in wages across the U.S., but I don't think you're going to get that back to the labor that you had pre-COVID. Certainly, ocean freight is going to be a tailwind for us going into 2023. I would say domestic freight should be a tailwind as well, but that will be partly dependent on diesel fuel prices that are above $5 now. And so it will be partly dependent on what happens with fuel. But most importantly, it will depend on top line sales.

My question is just, with all the inventory out there, not just in terms of apparel and footwear, but many categories, are you seeing any opportunities to expand the business into some new areas and new categories that maybe you haven't before just because the buys are so good?

Look, I would say, the merchants are out there looking for all kinds of buys. And yes, that does happen. Often you wind up opening up some new resources, which we have, as there's availability and the vendors are looking to partner with people. So yes, we're absolutely doing that, and that's a piece of it.

And Barbara, do you think that can continue?

I believe when you open up a resource or even start exploring a resource, even if it doesn't currently have merchandise, over time, if you revisit it, you will eventually access the resource. After the current supply surplus subsides, which we anticipate will extend into next year due to the excess merchandise, we will have more clarity on the complete range of products available since this November. I see potential opportunities and some areas within businesses we can explore for expansion, focusing on specific categories rather than entire businesses.

This is Jesse Sobelson on for Ike. We were just wondering, as we look to pre-COVID margins, I think it was mentioned a little bit earlier in the Q&A, you're hovering around 13% pre-COVID. But you mentioned some higher structural costs such as wages. This pre-COVID margin is still attainable sometime over the next few years? Or should we be thinking about a recovery, but maybe landing somewhere below those pre-COVID levels? How are you guys thinking about it?

Sure, Jesse. I wouldn't predict where it's going to land other than any return would happen over a number of years and wouldn't happen overnight. We would expect to have improved profitability over time is the way I'd answer that question.

Barbara, on your point about resetting the value proposition, have you seen turns pick up sequentially through the quarter? And is that what drove the in-store inventories to be so lean as you continued to lean in on markdowns? And then, Adam, you mentioned earlier an expectation of an easing of markdowns in Q4. Should we interpret that you're now reaching the level of turns that continue to be strong through the quarter and now you're happy with where your value proposition is? Have you seen the turns stay strong kind of exiting the quarter and into Q4?

Aneesha, regarding inventory levels, we have maintained these levels throughout the year. We prefer to stay proactive. This is our usual approach, and we will continue with it moving forward. The inventory levels in-store, in front of the customer, were higher compared to last year but lower than pre-pandemic levels.

Yes. And, Aneesha, building on that a little bit. Your question about the markdowns, we've layered some additional markdowns versus last year into our fourth quarter guidance. And that's really largely driven. We know this is going to be a highly promotional environment, and we'll see how highly promotional it is, but just want to be prepared for that.

Congratulations on the quarter. Regarding new stores, I understand you mentioned completing your 2022 store growth plans. Could you share some insights on new store productivity compared to your benchmarks and any additional information about the performance of these new stores?

Sure. So for us, a new store overall in the fleet of stores will typically come out of the box at 60% to 65% of the chain average. And that continues to be the case, even on the new store openings over the last couple of years.

Just 2 quick questions. On, I guess, dd's versus Ross, are the state performances, Texas, Florida versus California, what you said, is that holding true for both formats in terms of the sales performance? And then just on the other side of it, in terms of your mix or your opportunity in categories, what do you think in terms of where you outperformed your expectation in the third quarter, like which categories surprised you the most, I would say? Could you share that with us?

Sure. Regarding the question about state performance, we generally look at it on a consolidated basis, which we've talked about. I want to emphasize that while overall improvements were seen in the category, they continued to lag behind Ross. In terms of merchandise performance, shoes performed exceptionally well, and some of our standard core businesses also exceeded expectations. From a strategic standpoint, that is the plan moving forward.

This is Dan Stroller on for Simeon. On the topic of margin recapture, I think in the past, you've talked about leveraging added technology in-store or at the distribution centers for efficiency and cost reductions. Just wondering where you stand in that regard, or if there's more to come, basically what inning you're in, in that chapter.

I would answer that by saying we're constantly in the third or fourth inning. So we always have new investments we're making. Those include automation in the distribution centers and in stores. They're ranging from automated robotics in the distribution centers. We're piloting self-checkout in the stores, and also in the stores, more efficient ways to check inventory and take markdowns for our store associates. And we constantly have investments where we're trying to be more productive and efficient in the business.

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