Ross Stores Inc (ROST) — Q1 2023 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 first quarter 2023 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, despite continued inflationary pressures impacting our low to moderate income customers, first quarter sales were relatively in line with our expectations. Total sales of $4.5 billion, up from $4.3 billion last year, while comparable store sales rose 1%. Earnings per share for the 13 weeks ended April 29, 2023, are $1.09 on net income of $371 million. These results compare to $0.97 per share on net earnings of $338 million for the 13 weeks ended April 30, 2022. Cosmetics and accessories were the strongest merchandise areas during the quarter, while the Midwest was the top-performing region. dd's DISCOUNTS performance in the first quarter continued to trail Ross, reflecting the aforementioned inflationary pressures that continue to have a larger impact on our lower income households. At quarter end, total consolidated inventories were down 16% versus last year. Average store inventories were up 2% at the end of the quarter. Packaway merchandise represented 42% of total inventories versus 43% last year. Turning to store growth, we opened 11 new Ross and 8 dd's DISCOUNTS locations in the first quarter. We continue to plan for approximately 100 new stores 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 up 1% for the quarter, driven by an increase in transactions. First quarter operating margin of 10.1% was down from 10.8% in 2022. As expected, this decline primarily reflects higher incentive compensation versus last year when we underperformed our expectations. Cost of goods sold improved by 50 basis points due to a combination of factors. Merchandise margin was up 120 basis points, primarily due to lower ocean freight costs, while domestic freight costs declined by 60 basis points. Partially offsetting these two favorable items were higher distribution expenses of 65 basis points, driven primarily by unfavorable packaway-related costs and deleverage from the opening of our Houston distribution center. Buying increased by 60 basis points due to higher incentive compensation and occupancy deleveraged 5 basis points. SG&A for the period rose 115 basis points, mainly due to higher incentive compensation and store wages versus last year. During the first quarter, we repurchased 2.2 million shares of common stock for an aggregate cost of $234 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 2023. For the 13 weeks ending July 29, 2023, comparable sales are forecast to be relatively flat. Second quarter 2023 earnings per share are projected to be $1.07 to $1.14 versus $1.11 for the 13 weeks ended July 30, 2022. Our guidance assumptions for the second quarter of 2023 include the following: total sales are forecast to increase 1% to 4% versus the prior year. We plan to open 27 locations in the second quarter, including 18 Ross and 9 dd's DISCOUNTS locations. Operating margin for the second quarter is planned to be in the 9.8% to 10.1% range, down from 11.3% in 2022 as higher merchandise margin from lower ocean freight cost is forecast to be offset by an increase in expenses, primarily related to incentive compensation and store wages. We expect net interest income to be approximately $31 million. The tax rate is projected to be about 25%, and diluted shares outstanding are expected to be approximately 339 million. Now turning to the full year. Based on our first quarter results and guidance for the second quarter, comparable store sales for the 52 weeks ending January 27, 2024, are still planned to be relatively flat. We now project earnings per share for the 53 weeks ending February 3, 2024, to be $4.77 to $4.99 compared to $4.38 for the 52 weeks ended January 28, 2023. This guidance includes an estimated benefit to full year 2023 earnings per share of approximately $0.15 from the 53rd week.

Thank you, Adam. As noted on our last earnings call, we had expected fiscal 2023 to be another challenging year. This was especially true given the continued uncertainty in the macroeconomic, geopolitical, and retail environment. As a result of today's uncertain external landscape, especially the prolonged inflationary pressures negatively impacting our customers' discretionary spend, shoppers are seeking even stronger values when visiting our stores. In response, we remain focused on delivering the most compelling bargains possible while diligently managing expenses and inventory to maximize our opportunities for growth.

So Barbara, maybe given the pressure on your low to middle income or low to moderate income customer base that you cited, how do you feel today about your merchandise assortments across categories from that value perspective? And then how are you managing buys in the marketplace just given the current level of disruption across the apparel landscape today?

We weren't really satisfied with our results. As I look across the different businesses, some didn't perform as well as we expected, and we're addressing those issues. Our focus has been on improving value across the store for the past few months. We've made some progress overall, but it remains a significant focus for us to provide customers with the best branded bargains and values. We're on a journey, and the merchant team is highly dedicated to this effort, which is especially crucial for our mid- to lower-income customers.

Yes, just how you're managing buys given how much disruption there is in the overall apparel landscape? How much you're leaving, thinking about current open to buy and relative to maybe things opportunistic from a packaway perspective.

Okay. Well, we have enough open to buy for both packaway and to chase the business. So right now, the plan is postured that we would chase the business as we're coming across and we're monitoring the speed of spending. And the hotel, same scenario. Hotel inventories are basically at the same rate as they were last year. And so the merchants are out in the market seeking out deals and based on those deals, we make those decisions. So if a deal comes in one business and that wasn't really even planned for that business, we might take that plan up. So we're really looking for with the overarching idea that what we want to do is get the best possible values on the floor. So the merchants go to the market, and then there's discussions about what's out there. I know you know that there is pretty broad-based availability out there, maybe across most businesses anyway, in most brands in the market because as you know, supply fluctuates by type of product and vendor. But you have to kind of be out there and be in it to really see what's out there and then come back and then decide where do we want to take the deal. But that is our focus in both companies, delivering the best branded bargains that we possibly can.

So you're holding your comp guide for the year, though, you noted the consumer is looking for a deeper value and your merchants are focused on that. So I guess I'm wondering how the expected makeup of that flat comp has changed versus your expectations at the start of the year? And to the extent that there's perhaps some lower ticket involved, are there any margin implications we should be aware of?

Mark, it's Michael Hartshorn. Let me start by discussing the first quarter. The increase in transactions during this period, which serves as our indicator for customer traffic, was higher compared to last year. This is a positive sign for the return of customer traffic. The average basket size remained the same, and units per transaction were also flat, but we experienced an increase in sales at a lower average unit retail price. Looking ahead for the year, our outlook remains unchanged. We will continue to manage the business cautiously, remaining agile to chase trends while carefully managing expenses and inventory. As we progressed through the quarter and weather conditions improved, we noticed trends getting better on a multi-year comparison. This indicates to us that we have a healthy flow of traffic and that our overall outlook for the year remains stable.

Curious about geographic dispersion, maybe if you could talk about some of your big states performance in those states, specifically California. How the trends look from the beginning of the quarter to the end of the quarter? And if maybe you could talk about apparel versus home performance.

Sure, Paul. During the quarter, we observed an improvement in trends compared to pre-COVID levels, with April being the strongest month. Geographically, the Midwest emerged as the top-performing region among our larger markets. Texas outperformed the chain average, Florida was consistent with it, and California fell below the chain average due to challenging weather conditions in the West throughout the quarter. In terms of merchandise, accessories and cosmetics were our best performers, while overall, shoes exceeded the chain average, home products met expectations, and apparel lagged behind.

Michael, could you provide more details on California? How much of the performance was below the chain average? Did the gap between California and the rest of the chain decrease by the end of the quarter?

It did close, but we wouldn't go into specifics. It did underperform compared to the chain average, but it improved as the weather got better.

As you move through the quarter, did you see any signs of customers trading down into Ross or any other notable changes in consumer behavior?

Overall, it's difficult to assess sales due to various factors. The low-end customer remains under pressure from ongoing inflation, reduced SNAP benefits, and lower tax refunds, making it challenging to determine if there is evidence of customers trading down.

And the lower AUR in the quarter, was that all moving towards sharper price points? Or is there a mix component to that that we should factor in?

That's really off of a sharper price point. It wasn't generated by mix.

The merchandise margin had a nice uptick here in the first quarter relative to the last quarter. Can you talk about the drivers? I think you called out freight and then how you're thinking about that line item over the balance of the year?

Yes. Chuck, this is Adam. So I mentioned the merchandise margin grew by 120 basis points in Q1. Ocean freight was clearly the most impactful component here driving the improvement. Our performance in merchandise margin was in line with what we embedded in our guidance for Q1. And assuming rates stay where they are, I expect that to continue as we move through the year.

Barbara, I want to ask you about packaway, the 42% this year versus 43%. First and foremost, it sounds like you believe that your assortment is on trend, and then typically, when there are these kinds of late weather breaks to warmer weather across retail, it gives you the opportunity to chase into sort of known winters. Do you feel better about the assortment heading into the second quarter? And then, Adam, or Barbara, with frontline still being very promotional, does that somehow impede the ability to drive maybe higher AURs because the value is not as evident as it may be when frontline is a little bit less promotional?

Okay, Adrienne. So let's start with packaway, I think the first question was about packaway, the content at packaway? So the content at packaway, we feel good about that content at packaway. Last year at this particular moment in time was when we started to bring in goods because of all the carrier issues that went on whenever things sped up, we took goods and put them into packaway as we told all of you that we use later on in the year, really our direct imports. So the packaway that we have in there now is really closed out great deals that we feel very good about. So the percent might be the same, but the content is different. So that's the first one. The second one, in terms of the late weather break, I'm not sure I 100% understand what you mean by that.

So often when it has been cold in the Northeast, many retailers have struggled to meet their plans due to the extended cold weather. In the past, such poor weather transitions have typically provided opportunities, but I believe you addressed this in your earlier comments.

Yes, you're asking if there are additional great deals available due to favorable weather. That's an ongoing situation. The merchants are actively in the market, trying to close out their business, and this varies by type of business. There are indeed factors related to supply availability that contribute to this situation.

And the spread, the kind of wide the spread from frontline to your pricing?

I think you’re pointing out that the current environment is more promotional than it has been, and we need to consider our role in this promotional landscape. The competitive market remains strong, and we've observed an increase in promotional activities over the last few months, which I don’t expect to diminish anytime soon. What’s essential is that buyers are actively engaging in the market and collaborating with vendors to grasp two key aspects: brand availability and pricing. They recognize the need to sharpen their value propositions, which leads them to competitive shopping and awareness of what’s happening in stores. Vendors are providing insights on product availability and pricing, including information about excess goods and closeouts, which buyers are carefully studying.

This is Kate on for Ike. I guess just to hone in on the gross margin piece, you guys had a decent amount of volatility in both distribution and buying buckets last year within COGS. Can you walk us through how you think those line items progress through the rest of the year, maybe direction or magnitude?

Yes. Kate, this is Adam. So we'll take them individually. So ocean freight costs, a significant tailwind in Q1. Again, given all the volatility we've seen over time, don't want to get too far ahead of ourselves, but kind of what's embedded in the guidance is we'll continue to see that as a tailwind as we go through the balance of the year. Domestic freight, we called out the 60 basis points of improvement year-over-year. Again, highly dependent here on fuel prices. And obviously, there's wage increases embedded in those costs. But assuming those things stay stable, we would continue to expect that to be a tailwind for us as we go forward. The biggest piece that we've called out for some time, offsetting those benefits are incentive costs. So we gave you the details of that approximately in the call comments, I would also say in the second quarter, when we look at it, will probably be the most impactful quarter for us from an incentive cost increase this year versus last year. We also commented on distribution expenses. So again, driven by timing of packaway and then the planned deleverage from our newer distribution center in Houston.

Great. So it feels like this is kind of an ongoing narrative for the last year that you're not super happy with the value you're offering the customer. Though historically, I think you've proven super consistent and successful there. So I'm just wondering, has anything changed in the buying organization? Or what do you think the buying team is getting wrong now? And maybe how you're thinking about correcting this or putting initiatives in place to perhaps get this back on track?

I believe the value equation we've been focusing on has shifted over the last few months. We're now in a different position compared to a few months ago, both in terms of brands and their values. I don't think the merchants are failing; rather, we are experiencing an evolution. We are now very concentrated on providing compelling value as we observe our customers in both companies facing challenges with inflation and other current issues. We need to remain focused on delivering those values. The way we approach this has changed since six months ago and continues to evolve. We aim to ensure we have a broad assortment, fresh receipts, and branded merchandise, and we want to sharpen our branded values where suitable to enhance our offerings in the competitive retail landscape. I don't see this as something that isn't working; it's more about evolution. Our business has changed over the past year, and it's vital to provide strong value to our customers, especially now as the market becomes even more competitive and promotional. We need to keep that perspective in mind and improve our understanding of where to enhance our branded values. I view this as part of the ongoing evolution in all our businesses.

Any change in the percent of sales being driven by top vendors versus last year and then just versus a historical trend. Just wondering if concentration of the largest vendors has changed at all? And then just because it's coming up fairly frequently, any updated thoughts on shrink.

I'll start. It's Michael. Regarding shrink, it was slightly higher for us last year but not significantly so. We expect it will remain at or just above those levels in our estimates, but we typically review the financial impact during our physical inventory adjustment in the third quarter. As for the percentage of our top vendors compared to historical data, it fluctuates based on supply. One year, we might have a large amount of merchandise from one top vendor, and the following year, it could be less from them and more from another. So, it varies. I don't think our definition of top vendors has shifted significantly; the main changes come from the vendors themselves and the availability of their products.

As you think about the performance of dd's and what's happening in the environment, was there any differential in dd's performance in the fourth quarter to the first quarter and what you saw? And then just lastly, on the Bed Bath & Beyond locations that are available, if you were to get any, would that be in addition to the current run rate of store openings this year? Or would it be part of it?

Dana, on dd's, the sales trends continue to trail Ross' results during the first quarter. I wouldn't comment on the differential between fourth and first. Obviously, their customer faces even more macro headwinds relative to Ross', which is, I think, reflected in their underperformance. I would also say, though, similar to Ross, we are sharply focused on offering better values to help drive improved sales performance there. On Bed Bath & Beyond, it will no doubt provide opportunities for new store locations. We'll have to review each potential new site on a case-by-case basis to see if it's appropriate for us. But I would say it's not going to impact our 100 store opening plan for this year.

I guess just a question for me is as you think about what's happening in the macro, when you look at your good, better, best mix, are you migrating your offering to the lower end of the spectrum? I'm just curious just in terms of the buys or how you're thinking about the merchandising piece of it.

Sure. So we have a good, better, best strategy, and that is really driven by the assortment that we put on the floor and the values we put out there. So we want a tiered strategy because we're going to track a much broader set of customers. But that can move based on supply, based on availability, based on our purchases. So it fluctuates as you go.

As you consider the remainder of the year, are you not really focused on purchasing based on a good environment compared to better or best in your offerings?

It varies by business, and I can't say it's a company-wide strategy. It changes depending on the specific business, especially since our dd's customers are very price-sensitive. We're closely monitoring the values and pricing we set. Even at dd's, these factors fluctuate, and we are clearly aware of this, particularly regarding that customer.

Given the ongoing inflationary pressures in the macro, I'm wondering if you can provide updated thoughts on the longer-term path to recapturing pre-COVID operating margins? Are there any initiatives that you're contemplating to help drive that recovery outside of sharpening values and driving additional market share capture?

Thank you for the question, Brooke. Our long-term improvements in operating margins depend heavily on maintaining strong sales over a prolonged period. We are considering how long inflationary pressures will last, but we believe that we can gradually improve profitability over time. Regarding structural concerns, we are noticing some benefits from reduced freight costs, although these expenses are not yet at pre-pandemic levels. We are also experiencing wage pressures in our stores. We have guided our capital expenditures to be $810 million, with significant investment focused on expanding distribution center capacity and the opening of 100 new stores. A substantial portion of this investment will go towards technology that enhances efficiencies in our stores and distribution centers, including more automation and various store initiatives we’ve previously discussed.

It's about the weather's impact on your comp in Q1. Is that something you can quantify or maybe if that's a tough one, maybe give us the discrepancy roughly between California and the rest of the chain?

It's difficult to measure. I would say it didn't benefit our business. California was slightly below the average for the chain but did show improvement as the weather got better.

I just wanted to clarify. I think you said the 53rd week adds about $0.15. Could we expect between like $350 million to $400 million in sales? Is that a decent number to use for that week? Or is it a little less because it's a January week? Just curious.

Probably a little bit less than that, Marni, given that it's, as you said, given that it's January, early February.

That's what I figured. And then this came up on other calls, it looks like your traffic is good that people are looking for sharper deals, but you obviously called out accessories and cosmetics beauty, which tends to have a lower AUR. Are people gravitating towards the lower-priced items? Or as you've seen the weather improve, have you seen apparel come back in slightly higher AUR, but they're looking for the apparel items that are on sale or just at the better prices. I'm curious sort of what the dynamic is there.

Apparel faced challenges in the first quarter. I don’t believe it was primarily related to pricing. The assortments weren't quite what we expected. The issue could be related to price or product, but there are several factors at play. I can't pinpoint it to just pricing or markdowns; ultimately, I would say the assortment was the key factor. While the weather didn't help, I don't consider it to be a major enough influence to attribute the results to that alone. Our assortments were not where we wanted them to be, and we are actively addressing that issue. It's not simply about price or any single element; we have a clear agenda to improve, and our team is currently focused on this task.

It wasn't driven by mix. It was driven by being sharper priced across the assortment.

There was a noticeable softness across the apparel assortment. It wasn't specific to the average unit retail.

You asked that was AUR driven by mix in the business. It was not driven by mix.

On the apparel side, was there a general softness across all categories, such as men's Polo shirts, women's dresses, and kids' items? Or were there particular areas that required significant attention while others were performing adequately?

We're not going to go into details, but it's clear that some apparel businesses perform better than others. We won't provide specifics, but I'm not certain if you're suggesting something specific in one area. I understand what you're getting at.

I was actually feeling positive about it. Were you mentioning that the dresses were excellent?

Couldn't decide where you were going with that. Every business has businesses that were performing, some businesses didn't and so we're not going to get into specifics on that. What I would say is that the merchants are very diligently working on the assortments, whether it's delivering the right products, whether it's the values, I mean they're really highly focused on that right now.

Barbara, just on the availability across your good, better, best spectrum that you have. Is there any better availability within any one of those 3 segments as you speak to your merchants?

The supply is quite diverse. In most industries, there are usually multiple vendors for each product, and it's not limited to just one category. It tends to fluctuate, but overall, there's still a significant amount of supply. I wouldn't classify it into just one of those three segments; it's still quite broad-based.

Got it. And then just on the lower AUR common being driven by sharper price points. I guess within the context of the guide for the full year for flat comps, is the expectation that the AUR is likely to be lower throughout the rest of the year as well?

Putting out better value doesn't necessarily imply that your average unit retail price is declining. Our focus is on delivering significant value. Depending on the mix of good, better, and best products, it doesn't automatically mean the average unit retail price is falling. Our main goal is to enhance our branded values for the customer, and we believe this approach will drive sales and ultimately help us gain market share. These two aspects don't necessarily correlate.

It appears that you exceeded the lower end of your first quarter EPS guidance by approximately $0.10, but you're increasing the lower end of your full-year guidance by around $0.12. Could you clarify what the additional $0.02 is attributable to?

Yes. I think the better way to look at it is what we did on the top end. We beat the top end by 4, you lose a quarter in that, and then we raised the full year by the $0.04.

Your guidance suggests that your two-year comparable sales for this quarter were down 6%, and it indicates a slowdown to approximately down 7% for Q2, followed by an improvement in the latter half of the year to near breakeven for your stacked comparisons. Can you elaborate on your expectations for the year’s progression and explain your cautious outlook for Q2 contrasted with a more positive view for the second half?

Sure, Aneesha. I think it's hard to look at these on a 2-year stack with all the fiscal stimulus and COVID. So we're really looking at it, pre-COVID, what's changed on a 4-year stack and how that's progressed over time. And we went into the year and had a plan in the first quarter. What we saw is that 4-year stack improved as we move through the quarter and weather improved and exited in a place that would support that stack guidance for the year.

Okay. So just to clarify, you are embedding an improvement in the 4-year stack through the course of the year?

Correct, yes.

It's Krista asking for John. I have a quick question about inventory. You've experienced several significant declines over the past two quarters. I'm curious about your outlook for the remainder of this year. Should we anticipate continued declines on a quarterly basis until the year's end, or do you believe you'll eventually align with your sales growth expectations?

If you look at the first quarter, we saw a decline of 16%, but this was relative to high inventory levels from last year when supply chain issues improved and we had an excess of early receipts. As we progress through the year, that elevated inventory from last year began to decrease in the third and fourth quarters, making comparisons more relevant. However, we still anticipate lower levels due to the surplus inventory we experienced in the first half of the year.

Thanks for joining us today and for your interest in Ross Stores.