Ross Stores (ROST.US) |High Quality 2Q Beat & Raise; Own Off-Price; Remain OW

ROST reported 2Q EPS of $1.32 (14% above Consensus at $1.16) with upside driven by +5% same-store-sales (> Street 1%) and GPMs +185bps y/y to 27.7% (> Street 26.4%) partially offset by SG&A deleverage of 180bps (vs. Street 150bps deleverage).

Looking ahead, mgmt raised its FY23 EPS guidance to $5.15 to $5.26 (> $4.77 to $4.99 prior & Street at $4.97) driven by flow-through of more favorable top-line (i.e. +2-3% raised FY23 SSS guide > Flat prior), which implies 10.9% to 11.1% EBIT margins by our math (> 10.3%-10.7% prior). Specifically on cadence, mgmt expects 3Q EPS of $1.16-1.21 (vs. Street $1.17) on same-store-sales of +2-3% (> Street +0.8%) and 4Q EPS of $1.58-1.64 (> Street $1.55) on a same-store-sales +1-2% (vs. Street 1%). Digging deeper, management’s 2H23 +2% same-storesales guidance at the midpoint embeds a +3.0% 4-yr comp CAGR (more/less matching 2Q’s +2.9% CAGR = no embedded accel/decel), though we note 2H22’s CAGR sequentially accelerated vs. 2Q by ~100bps, which if true for this year would imply a +mid-single-digit SSS upside scenario.

#1: 2Q Top-Line Beat w/ Traffic Momentum: ROST reported +5% same-store sales (500bps ahead of mgmt’s Flat SSS guide) principally driven by traffic with average basket Flat (w/ UPT slightly up Y/Y offsetting a lower AUR). Breaking down the drivers of 2Q comp outperformance vs. plan, CEO Rentler’s commentary positively shifted on 2 key topics citing today: (i) “customers responded well to our improved value offerings throughout our stores” relative to “the merchandise from a value perspective, first, let me lead with, we weren't really satisfied with our results. So as I look across the different businesses, we had some businesses where the business didn't perform as well as we had expected, and we're addressing those issues” in 1Q and (ii) “easing inflationary pressures” relative to “prolonged inflationary pressures continue to negatively impact our low-to moderate income customers’ discretionary spend” in 1Q.

Importantly on the cadence of the quarter, management cited relatively strong comps across the quarter on both a 1-yr basis and multi-year basis, which implies a sequentially accelerating comp trend in June/July to exit the quarter by our work relative to May given easier y/y comparisons (consistent with our 8/14 2Q Preview). By category, cosmetics and accessories were the strongest merchandise areas during the quarter & performance across regions was broad-based. Additionally, management cited both Ross & dd’s Discounts comp performance improved sequentially QoQ due to better merchandise assortments & moderating inflation, with the internal merchandising goal to provide better-branded value bargains for the customer by sourcing broadly across good/better/best categories & therefore reaching a wide breadth of customers.

#2: 2Q EBIT Margin Incremental Flow Through > Expectations: On the bottom-line, 2Q’s EBIT margin exceeded mgmt’s expectations at 11.3% (vs. 9.8% to 10.1% guidance), implying 135bps of incremental EBIT margin flow-through on the 500bps comp beat (or +27bps of EBIT margin on a per comp point basis better than management’s algorithm of 10-15bps of incremental flow-through per every 1% comp point ahead of plan). Breaking this down further, 2Q GPM expanded +185bps to 27.7% (> Street 26.4%) driven by merchandise margin expansion of +200bps Y/Y (primarily driven by favorable ocean freight costs tailwinds y/y), domestic freight tailwind of +60bps, occupancy leverage of +20bps, and distribution cost tailwind of +5bps, partially offset by 100bps of buying deleverage (higher incentive compensation – noting 2Q represented the peak anticipated impact from IC timing). 2Q SG&A $s grew +21% Y/Y, equating to 180bps of leverage Y/Y to 16.4% (vs. Street 16%) tied primarily to the incentive compensation reset

#3: Breaking Down Mgmt’s 2H23 Implied Guidance: Mgmt’s outlined 3Q EPS guidance of $1.16-1.21 (> Street $1.17) based on +2-3% same-store-sales growth (= +13-14% 4-yr comp stack vs. 2Q +13%) citing “confidence in the merchandise assortments we’re providing the customer” & “we believe it is prudent to continue to plan the business cautiously.” Specifically, management’s 3Q guidance embeds a 10.3% to 10.5% EBIT margin (vs. Street 10.8%) or +60bps of expansion Y/Y, driven by the benefit from lower ocean freight costs & domestic freight costs (both anticipated to look similarly to 2Q) more than offsetting increased incentive compensation & store wages (noting 2Q’s IC headwind represented the peak of the year). Additionally, management cited ‘some benefit’ anticipated moving through 2H23 tied to lapping elevated markdown levels from last Fall (assuming topline execution continues). Into 4Q, management guided EPS $1.58-1.64 (> Street $1.55) based on SSS +1- 2% (vs. Street +1%), which prudently embeds a 11.5% 4-yr comp stack vs. 2Q’s +13%, with COO Hartshorn citing an expected more promotional holiday season reflected in the 4Q same-store-sales guidance (despite current business momentum today). On the bottom-line, this implies +125bps of 4Q EBIT margin expansion by our math (vs. Street +110bps) supported by benefits from the 53rd week in addition to continued ocean freight recovery (albeit considerably less than 3Q’s anticipated benefit given Y/Y comparisons), domestic freight recovery, and partial markdown recapture by our work

Ross Stores remains favorably positioned in a growing off-price pie with market share opportunity from dept. store share loss and white space remaining for unit growth with the company’s 2,500-store saturation target implying 10+ years of 5-6% annual sq. ft. growth (~90/year at less than two-year payback). Mgmt. is confident in a low-double-digit multi year bottom-line algorithm with its lower-income core-customer profile (66% cash transaction), strong value proposition (20-60% below AMZN/Dept store pricing), and building balance sheet ($1.1B FCF generation by our FY22/23 model) providing model insulation in an evolving retail landscape.

We raise our Dec ’24 PT to $137 (vs. $135 prior) based on 22x our 2025 EPS (= 2.0x pre pandemic by ROST’s LDD% EPS algorithm).

There is risk that in a difficult consumer discretionary environment investors could award lower than average multiples to retailers that have exposure to the moderate to low-end consumer. Additionally, comp momentum that we have seen over the past few months could slow down and pressure our earnings estimates and cause the stock to underperform the other names in our group.