2023-10-08 02:12:50 ET
Summary
- ROST reported strong Q2 earnings with comp store sales growth of 5% YoY and net sales of $4.9 billion.
- Gross margins increased by 185 bps YoY, but operating margins remained flat due to wage costs and higher incentives.
- ROST's traffic has consistently declined in Q3, indicating potential challenges for comp sales growth in the future.
- We remain skeptical as downside risks are likely to intensify heading into H2 with increasing promotional activity.
Investment Thesis
In continuing our coverage of Ross Stores ( ROST ), we had rated ROST as a Sell as a result of the inflationary headwinds impacting its core customer and potential PE derating as the earnings pressure intensify. The company garners a premium as a result of its 'defensive' nature, however, the company has been experiencing declining traffic compared to other off-price retailers and its core consumers continue to be challenged as a result of economic pressures and recently commenced student loan repayments. Insiders have been net sellers in the stock having sold shares worth ~$10 mn in the past 3 months. We reiterate our Sell rating but raise the target price to $96 driven by stronger than expected H1 performance.
Strong Q2 Earnings
ROST reported strong Q2 earnings with comp store sales growth of 5% YoY lapping a 7% decline last year and accelerating from 1% growth in Q1. Net sales jumped 8% YoY to $4.9 bn and came in ahead of the consensus expectation pegged at ~$4.7 bn. The robust growth was driven by higher traffic while average basket remaining flat with slightly higher units per transaction but lower average unit retail prices reflecting negative mix shifts. Outperforming categories included cosmetics and accessories while Home and footwear also performed above remained at the chain average. While apparel underperformed, the category improved sequentially and reported sales above management's expectations. Within ROST's formats, it noted Dd's Discounts trailing Ross given the outsized impact on lower-income consumers relative to Ross Dress for Less ($60 - $65k household income for Ross vs $40-$45k for Dd's Discounts).
Gross margins were up 185 bps YoY driven by 200 bps expansion in merchandise margin as a result of freight benefits along with occupancy cost leverage partially offset by deleverage in buying costs. However, operating margins remained flattish as SG&A deleverage due to wage costs and higher incentives largely offset the gains in gross margins. Inventories fell 15% YoY with average store inventories up 4% noting the company continues to see good availability of the inventory.
Management guided for Q3 comps growth of 2-3% and further expects it to decelerate to 1-2% in Q4 as it expects a more promotional environment heading into the holiday season. It expects gross margins to be accretive as it laps higher markdowns from the previous year as well as continued tailwinds from freight.
The company bought back $230 mn in stock during Q1 with an additional $235 mn in repurchases during Q2 bringing to a total of ~$465 mn for 2023 YTD with an additional $465 mn left for the year under its repurchase program.
H2 Preview
According to data from Placer.ai, weekly average traffic for ROST has consistently declined into Q3 with September turning negative. This compares to a consistent high single digit / double digit growth observed in other off price retailers, TJX Companies ( TJX ) and Burlington ( BURL ).
We expect Q3 comp sales growth to be below the management guide of 2-3% growth and expect Q3 sales growth to be ~5% driven by net new stores of 70-80 compared to last year as a result of decline in its weekly average traffic (although July was strong). We believe ROST will benefit from customers trading down, however, its core consumer will continue to face pressure as a result of economic pressures along with upcoming student loan repayments. We expect gross margins to improve by 150 - 200 bps driven by freight tailwinds and lapping higher markdowns last year. However, ROST's SG&A dollar growth accelerated in Q2 increasing 8% sequentially on top of the 3% sequential increase in Q1, deleveraging 150 bps for H1. We expect the SG&A to deleverage due to wage cost pressures which will largely offset any gains in the gross margins and assume flattish operating margins. In addition, we expect Q4 margins to shrink as a result of elevated markdowns and higher promotional activity with flattish to slightly declining comp sales growth over last year.
Valuation
ROST's Seeking Alpha Valuation grade is 'D-' as the Street ascribes a premium to the stock as a result of its relative defensive nature of the business. However, we believe the downside risks will intensify as its core consumer continue to pull back on the discretionary spending with declining traffic along with a decrease in the average basket size. In addition, its exposure to weaker categories such as home and apparel is expected to continue be a significant underperformer.
We value ROST at 18x Fwd PE which is in range compared to its long term average and raise the target price to $96 as a result of strong H1 performance. We reiterate Sell rating and remain skeptical on the company's ability to eke out higher comp sales growth going forward as its core consumer continue to face increasing challenges along with recently commenced student loan repayments and the company experiencing significant decline in traffic through Q3 which has been typically a driver for the comp sales growth.
Risks to Rating
Risks to rating include
1) Higher than anticipated tailwinds from freight and lower markdown activity can boost gross margins
2) Wage cost pressures may moderate which could lead to improvement in operating margins
3) Continued stock repurchases and any increase in shareholder activity can lend further support to the stock
4) Improvement in demand environment can aid comp sales growth
Final Thoughts
ROST has been one of the high performing stocks within the off-price retail as consumers tend to flock to them under inflationary conditions providing better value for money. We believe the company has done better than anticipated in H1 driven by strong comp sales growth, however, its operating margins remain underwhelming as it continue to face wage cost pressures. In addition, Insiders have been selling the stock and have sold the shares to the tune of ~$10 mn over the last 3 months. We reiterate our Sell rating and believe there are significant downside risks as the company enters H2 and beyond.
For further details see:
Ross Stores: Good H1 But Downside Risks Prevail