ROST - Ross Stores: Promising Performance Fuels My Optimistic Outlook

2023-09-18 15:50:31 ET

Summary

• ROST reported strong Q2 results with impressive EPS and revenue growth driven by increased customer traffic and favorable ocean freight costs.
• Management has an optimistic outlook for Q3 and raised guidance for FY2023, indicating confidence in ROST's future growth.
• The decline in inflation and favorable freight trends contribute to a positive outlook, leading to a higher projected net income margin for FY24.

Summary

I'm following up on my coverage of Ross Stores ( ROST ), where I previously recommended a buy rating due to my expectation that ROST is poised for ongoing margin growth, as prior challenges in freight transform into favorable tailwinds. Additionally, the present macroeconomic conditions play to the company's advantage in my view, given its emphasis on value for consumers with lower to moderate incomes, presenting the potential for enhanced gross margins.

This post is to provide an update on my thoughts on the business and stock. ROST reported impressive Q2 results. Growth is mainly fueled by increased customer traffic due to the improving inflationary pressure and improved ocean freight costs. I also believe management's positive outlook for the third quarter and the increased guidance for fiscal year 2023 indicate their confidence in ROST's future growth. Therefore, with increasing retail spending and decreasing operating costs, I expect ROST's strength to continue into the latter half of 2023.

Investment thesis

ROST reported strong second quarter results, surpassing my expectations. The reported adjusted EPS stood at an impressive $1.32. Additionally, the company posted revenue of approximately $4.93 billion, reflecting a notable growth of 7.7% year over year. The primary driver of this revenue surge was increased customer traffic. Moreover, ROST showcased a solid GM of 27.7%. This growth in GM was predominantly due to more favorable ocean freight costs.

In a promising move, the management offered an optimistic outlook for the third quarter and raised its guidance for fiscal year 2023. This upward adjustment in the guidance reflects the management's strong confidence in ROST's potential for future growth and success in my view.

ROST experienced a notably stronger comparable sales performance in the second quarter, with consistent strength seen throughout the entire quarter. Management made a point of emphasizing that higher customer foot traffic was what drove the increase in comparable sales. Despite a slight increase in units per transaction [UPT], the average unit retail [AUR] was slightly lower, resulting in a flat basket. Breaking it down further, there was a noticeable improvement in discounts at dd's Discounts, although the overall performance across all banners slightly lagged behind that of the flagship Ross banner.

I anticipate that this upward trajectory in comparable sales, driven by increased customer foot traffic, will continue into the upcoming quarters. The easing inflationary pressures observed since the beginning of the year, with a notable drop from around 9% in June 2022 to approximately 3% in June 2023, are expected to play a significant role. This decrease in inflation has contributed to heightened consumer spending, further supporting the positive trend in comparable sales.

The expansion of merchandise margins helped ROST achieve a year-over-year increase in gross margin. The decrease in ocean freight costs made it possible for this growth in merchandise margins. Looking forward, I anticipate continued favorable trends in freight for the remainder of the year, given the substantial influx of new container capacity coupled with a slowdown in freight demand and the successful resolution of congestion in the ocean freight industry.

This positive outlook leads me to project a higher net income [NI] margin as compared to consensus. I projected a NI margin of 11% for FY24, higher than the consensus of 8.6%. Given the decline in ocean freight and the uptick in traffic, I anticipate a better NI margin. In the second quarter, the NI margin improved to 9% vs. the previous 8.3%. This improvement in the NI margin further strengthened my belief that my higher projected margin is fair.

Valuation

I believe the fair value for ROST based on my DCF model is $141. My model assumptions are according to my updated view on ROST. Anticipating the shift from previous freight challenges to advantageous tailwinds, I foresee ROST sustaining its margin growth. My growth expectations align with the consensus, typically in the mid-single digits. However, I diverge from the consensus regarding profitability, firmly asserting that margins should rebound to historical levels more swiftly. I firmly believe ROST can attain a profitability level akin to a normalized pre-COVID period, especially given the conducive operational environment, unless there are specific reasons preventing it. The current setting is optimal for the company's success in my belief.

Peers include TJX Company ( TJX ) and Burlington Stores ( BURL ). The median forward earnings multiple peers are trading at is 22.66x while ROST is trading at 21.39x, the expected median 1Y growth rate is 8% while ROST is also 8%, and peers have similar EBITDA margin at mid-teens range. Based on these, I think ROST is trading at a relatively fair multiple. Therefore, I used ROST's current forward earnings multiple of 21x in my model. I maintain my buy rating.

Risk

In a challenging consumer discretionary landscape, retailers catering to the moderate-to-low-end consumer segment, such as ROST, may face the risk of being assigned below-average valuation multiples by investors. Furthermore, the momentum in comparable sales witnessed in recent months might decelerate, potentially impacting my estimates and resulting in the stock underperforming compared to other companies within the sector.

Conclusion

ROST's second quarter results exceeded my expectations with an impressive adjusted EPS of $1.32 and revenue growth of 7.7% YoY, both driven by increased customer traffic. Favorable ocean freight costs had a significant impact on the solid gross margin of 27.7%. Management's optimistic outlook for Q3 and the upward guidance for FY2023 reflect their strong confidence in ROST's growth prospects in my opinion. Notably, despite a flat basket due to a slight decline in average unit retail, comparable sales were robust in Q2. The decline in inflation has positively impacted consumer spending, aligning with the upward trajectory in comparable sales. Looking ahead, expectations of continued favorable freight trends and a slowdown in freight demand contribute to a positive outlook, prompting a higher projected net income margin of for FY24, exceeding the consensus estimates.

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