ROST - Ross Stores: Expect Growth To Accelerate In 2H23

2023-03-30 06:17:57 ET

Summary

• Ross Stores reported a 4Q22 EPS beat, but its FY23 outlook was below expectations.
• ROST's emphasis on offering greater value to customers is expected to lead to increased market share and more favorable profit margins over time.
• Management astuteness in locating cost-cutting opportunities and potential trade-down tailwinds may lead to earnings acceleration.

Overview

Following my initial article, I am updating my thesis. Despite reporting a 4Q22 EPS beat, Ross Stores ( ROST ) provided an FY23 outlook that was below expectations. Based on management's projection of little change in comparable sales and a slower rate of growth compared to the past three years, I believe that ROST is anticipating a cautious economic environment in the 1Q and throughout the fiscal year. Despite the prudence exhibited by ROST in the face of rising inflationary pressures, I remain confident that the company's emphasis on offering greater value to customers will lead to gains in traffic and sales momentum. This should lead to increased market share and more favorable profit margins over time. I reiterate my buy rating from my initial article .

4Q22 overview

With better revenue performance thanks to outperformance in Florida and strong results in footwear, ROST's 4Q22 EPS of $1.31 surpassed the consensus' $1.24 forecast. Despite a lower-than-anticipated gross margin, management's shrewdness on the cost line was greatly appreciated. However, total top-line failed to accelerate on an underlying basis, so comps came in a little lower than I expected (I was expecting the higher end of low-single digits and not 1%). I believe that the fact that ROST's comparable sales came in lower than expected is a sign of the continuing difficulties faced by the company's mostly low-income customers, and it implies that it may take until 2H23 for revenue to pick up again, once inflation subsides. I believe this persistent consumer pressure is reflected in management's flat FY23 comps guidance, which has resulted in a downward revision of consensus estimates.

Thesis update

My fundamental perception is that sales should resume their upward trajectory. The company could then revert to its pre-Covid earnings growth algorithm. So far, according to management, there were no indications of a consumer downturn or significant changes in spending across income levels. The fact that management is commenting on this trend almost 2 months into the year bodes well for the rest of the year as I expect the trade down benefits to become more apparent with the ongoing inflation - which will help with accelerating ROST growth. think this sets up a favorable environment for FY23 growth acceleration thanks to the ROST's enhanced value proposition and potential trade down tailwinds. I believe heightened inflation will continue to have an impact on consumer, and while inflation forces a trade down movement, an elevated inflation environment will cut overall spending, which hurts ROST. My concern is that ROST will only be able to deliver the expected growth in 2H23, given that inflation could remain elevated through at least 1H23 (when things start to ease and ROST will reap the benefit from the trade-down movement). In addition, with wage and cost inflation weighing on the company's finances, ROST will need to see both comp growth and strong revenue performance in order to achieve margin expansion and results consistent with its pre-Covid algorithm. From this perspective, it seems likely that ROST will remain range-bound for the time being as investors search for signs that growth can accelerate.

Nevertheless, I anticipate that ROST will meet its expectations as the economic conditions are likely to improve more widely, and households may spend their excess savings stocks. Furthermore, as energy prices decline, consumers may experience an increase in their spending power, particularly those with lower incomes. One thing that could boost the stock price in the first quarter of 2019 is if management is able to beat its own guidance, which has led to earnings being revised down. I think a significant beat would be good news for expectations and mood given how conservative the guide is.

More on margins

The company has lapped significantly higher costs from the prior year, and management believes that this will have a positive effect on gross margins in FY23 and 1Q23. These gains are mitigated to some extent, however, by the higher business costs brought on by wage and fuel increases, as well as a true up in incentive compensation. Given these increased expenses, I anticipate that ROST will maintain its astuteness in locating cost-cutting opportunities. This would further help with lowering the hurdle to beating 1Q23 guidance. Given that this commentary is made almost 2 full months into the quarter, I have a feeling that management might have already done save of this cost cuts, which makes the guide seem even more conservative.

Thoughts on recent inventory trends

Many investors, I believe, are fixated on inventory issue in the retail industry. Briefly reviewing the earnings reports of competitors leads me to believe that there has been some early success in right-sizing inventory levels, especially at department stores, as measured by the ratio of inventory to sales, which has improved sequentially on a year-over-year basis. Although there are still some remaining effects of high stock levels in certain verticals, I think this was probably caused by multi-brand retailers cutting back on purchases, an increase in unit prices, and the early shipment of spring inventory. In addition, many brands and retailers have promised to slow the expansion of their inventory, which should result in a reduced supply in the second half of 2023. A surplus of inventory in the overall environment creates a better buying opportunity for off-price retailers, which could have a positive effect on ROST. As such, this could be a catalyst if management can execute well.

Conclusion

Despite ROST's below-expectations FY23 outlook, I maintain my confidence in the company's ability to offer value to customers and drive traffic and comparable sales momentum. While the ongoing challenges faced by ROST's low-income customer base may persist, I believe that the company's enhanced value proposition and potential trade-down tailwinds will lead to growth acceleration in the future. Overall, I maintain my buy rating on ROST.

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