Ross Stores, Inc. (ROST) Q2 2014 Earnings Report, Transcript and Summary

Good afternoon, and welcome to the Ross Stores Second Quarter 2014 Earnings Release Conference Call. [Operator Instructions] Before we get started, on behalf of Ross Stores, I would like to note that the comments made on this call will contain forward-looking statements regarding expectations about future growth and financial results, including sales and earnings forecasts and other matters that are based on the company's current forecast of aspects of its future business. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from historical performance or current expectations. Risk factors are included in today's press release and the company's fiscal 2013 Form 10-K and fiscal 2014 Form 10-Q and 8-Ks on file with the SEC. Now I'd like to turn the call over to Barbara Rentler, the company's Chief Executive Officer.

Good afternoon. Joining me on the call today are Michael Balmuth, Executive Chairman; Michael O'Sullivan, President and Chief Operating Officer; Gary Cribb, Executive Vice President, Stores and Loss Prevention; John Call, Executive Vice President, Finance and Legal; Michael Hartshorn, Senior VP and Chief Financial Officer; and Connie Wong, Director of Investor Relations. We'll begin with a brief review of our second quarter and year-to-date performance, followed by our outlook for the second half of fiscal year. Afterwards, we'll be happy to respond to any questions you have. As noted in today's press release, second quarter sales performed at the high end of our expectations, as today's value-focused consumers continue to respond to our wide assortment of competitive name-brand bargains. Merchandise gross margin was above plan, which, coupled with strong expense control, enabled us to deliver quarterly earnings per share that were above the high end of our guidance. Earnings per share for the 13 weeks ended August 2, 2014, increased 16% to $1.14, up from $0.98 in last year's second quarter. Net earnings for the period grew 12% to $239.6 million. Second quarter 2014 sales rose 7% to $2.730 billion, with comparable store sales up 2% on top of a 4% gain in the prior year. For the 6 months ended August 2, 2014, earnings per share grew 12% to $2.30, up from $2.06 last year. Net earnings year-to-date rose 8% to $483.5 million, up from $447.7 million last year. Both the quarter and first 6 months results include a onetime benefit to earnings equivalent to approximately $0.02 per share from the favorable resolution of an outstanding legal matter. Sales for the first 6 months of 2014 increased 6% to $5.410 billion with comparable store sales up 2% on a consolidated basis versus a 3% gain in the same period last year. Same-store sales at dd's DISCOUNTS also increased for the quarter and year-to-date periods, driving solid gains in its profits. The strongest merchandise category for the quarter at Ross was Juniors, while the Midwest and Mid-Atlantic were the top-performing regions. For the second quarter, earnings before interest and taxes grew to a record 14.3% of sales, up from 13.6% last year. This increased level of profitability was driven by a 25 basis point improvement in cost of goods sold, mainly due to a higher merchandise gross margin and a 45 basis point decline in selling, general and administrative expenses, which benefited from tight expense control and the resolution of the aforementioned legal matter. As we ended the second quarter, total consolidated inventories declined about 5% compared to the prior year, with average in-store inventories down about 2%. Packaway was 43% of total inventory compared to 46% for the same period last year. Our expansion program remained on track in the first half with the opening of 53 new Ross and 14 dd's DISCOUNTS. We continue to target about 95 new locations for the full year in 2014, comprised of approximately 75 Ross and 20 dd's DISCOUNTS. Now Michael Hartshorn will provide further color on our second quarter results and details on our second half guidance.

Thank you, Barbara. The 2% comparable store sales gain in the second quarter was mainly driven by the growth in the size of the average basket, with the number of transactions flat to last year. As mentioned earlier, operating margin grew by about 70 basis points in the quarter to a record 14.3%. A 25 basis point improvement in cost of goods sold was mainly driven by higher merchandise margin, which grew by about 35 basis points over last year. In addition, freight and buying costs improved by about 10 and 5 basis points, respectively. These favorable results were partially offset by a 15 basis point increase in distribution costs and about 10 basis points of deleveraging on occupancy. Selling, general and administrative costs improved by about 45 basis points due to tight expense control and an approximate 20 basis point benefit from resolution of the aforementioned legal matter. During the second quarter, we repurchased 2.1 million shares of common stock for a total purchase price of $139 million. Year-to-date, we have bought back a total of 4.1 million shares for an aggregate price of $277 million. We remain on track in 2014 to buy back about $550 million in common stock, which would complete the 2-year $1.1 billion authorization approved at the beginning of 2013. Let's now turn to our second half guidance. For the 13 weeks ending November 1, 2014, we continue to project same-store sales to increase 1% to 2% and are forecasting earnings per share to be in the range of $0.83 to $0.87, up from $0.80 in last year's third quarter. For the 13 weeks ending January 31, 2015, we are also planning same-store sales to be up 1% to 2%, with earnings per share projected to be $1.05 to $1.09, up from $1.02 for the 13 weeks ended February 1, 2014. As a reminder, our second half guidance incorporates interest and occupancy costs associated with the acquisition of our New York buying office and the opening of our new distribution center in Rock Hill, South Carolina. Now I'll provide some additional operating statement assumptions for our third quarter EPS targets. Total sales are expected to grow about 5% to 6%, driven by a combination of new store growth, and as previously mentioned, same-store sales that are forecasted to be up 1% to 2%. We plan to open 28 new stores during the period, including 20 Ross Dress for Less and 8 dd's DISCOUNTS. We are targeting operating margin to decline 10 to 30 basis points versus last year. Net interest expense for the third quarter is planned to be about $2 million. Our tax rate is expected to be 36% to 37% and weighted average diluted shares outstanding are estimated to be about 208 million. Moving to our outlook for the full year. We are now projecting earnings per share for the 52 weeks ending January 31, 2015, to be in the range of $4.18 to $4.26, up from $3.88 in fiscal 2013. Now I'll turn the call back to Barbara for closing comments.

Thank you, Michael. To sum up, our ongoing focus on delivering compelling values on name-brand fashions for the family and the home throughout our stores drove respectable sales increases and solid earnings per share growth in the first half of the year. We also achieved these gains in a very challenging climate for apparel retail, especially given the ongoing difficult macroeconomic backdrop that continues to pressure our customers' discretionary spending. Looking ahead to the second half, we will continue to offer our customers competitive discounts on wide assortment of desirable merchandise, while also running our business with lean selling store inventories. As an off-price retailer, we have the flexibility to buy closer to need and will continue to stay very liquid with plenty of open-to-buy to take advantage of the great opportunities we expect to see in the marketplace over the balance of the year. We remain confident in the resilience of our off-price business model and our ability over time to successfully execute the proven strategies that have enabled us to deliver solid financial results even in challenging climates. To provide the foundation we need to maximize our growth over the longer term, we will continue to invest in important infrastructure assets, such as new distribution centers and the purchase of our New York buying office. Our most important focus is, and always will be, our unwavering commitment to offering shoppers the best bargains possible. We are confident that the ongoing investments we are making and our merchandise organizations, people and processes will further strengthen our ability to deliver the value our customers expect. Consistently delivering on this mission will always be the key to optimizing our potential for future sales and earnings growth. At this point, we would like to open up the call and respond to any questions you might have.

[Operator Instructions] Your first question is from Brian Tunick with JPMorgan.

I guess, Barbara, curious on your comments about the Juniors category. I know it's been a standout now for at least a year or 2. But wondering what other categories you also are excited about and you see as an opportunity to drive comps in the back half. And then on the flat traffic result -- and I know, obviously, also coming off a couple of years of strong results. But can you maybe highlight in addition to marketing maybe what are some other things that you and the organization are looking at in order to improve on the flat traffic numbers?

First, let me start with the comments on Juniors. Yes, our Juniors has been one of our strongest business for years. I would also say that we feel pretty strongly that we're making great progress on our home business. We have, really, in the second quarter progressed in our assortments, and we -- excuse me, just a second. We're moving in the right direction. We stabilized our leadership, and we've identified some ideas to attack the business. So in the second quarter, home ended in line with the chain, but the sales progressed as the quarter progressed. We're actually feeling pretty positive about home for the back half and for gift-giving, and we feel that there's really more to come in that business.

And then Brian, on the second question about traffic, as Barbara mentioned in her remarks traffic levels were flat in the second quarter versus last year. In terms of what we're doing to stimulate traffic -- mainly, our focus is always to improve the assortments. We find that's always the most effective way to drive traffic [ph]. So basically, the things that Barbara just highlighted, Juniors, home, et cetera, those are really going to be the things that stimulate traffic in our stores.

The next question is from Bob Drbul with Nomura Securities.

I guess, the question that I have is with the Midwest performing at the top of the chain right now, does that impact your geographic plans for the region? And can you comment a little bit more about the -- some new store opening and how the new store productivity are tracking?

So Bob, yes, as Barbara has said in her remarks, we're very happy with how the Midwest performed in the second quarter. It's actually the second quarter in a row where the comp performance has been pretty good. Now I would caution you, in 2013, we were not happy with the trend in the Midwest, and we made some changes to the assortments. So those changes have started to pay off, and that's why we are seeing the performance we are seeing. However, we are now going into the back half of the year. The weather obviously gets cooler, and cold weather assortments are very important in that region. So we're going to need to get that right, and we're focused on that. In terms of new stores more generally, we're pretty happy with how new stores are opening. And I would say that's been true for the last couple of years. Our new store productivity has been very good. We've been very happy with it.

The next question is from Ike Boruchow with Sterne Agee.

Question about the inventory packaway about 3 points lower year-over-year. Is there anything more to that in terms of the buying that you -- that transpired during the quarter, the buying environment? Anything you could share?

Well, what I would say is that in the second quarter, we really kept ourselves liquid, and we were able to flow a lot of the great deals that we got and pass along the bargains to the customer.

The next question is from Daniel Hofkin with William Blair & Company.

Question, I guess, just about the second half guidance a little bit, and not so much on the comps, but the margins that you're expecting. You just had a quarter where, obviously, some of it was the legal settlement but still a nice improvement in the -- both the gross margin and SG&A. So just wondering, aside from the 1 to 2 comp versus the 2 that you just reported, what would make the operating margin decline 10 to 30 in the third quarter? Is that just conservatism? Or are there some other factors there related to some of the investments that you're making?

Dan, in terms of the back half guidance, what we said in the comments is the infrastructure investments, we're making the opening of a new [indiscernible] purchase of the New York buying office. Those, along with the legal settlement in the second quarter, that obviously won't repeat in the second half. These represent the difference between the first half EPS growth and the high end of the second half guidance. In terms of EBIT margin impact, the infrastructure investments represent roughly 30 basis points of EBIT margin, along with the additional interest costs to finance the New York buying office.

Okay. And can you just remind us again kind of how that infrastructure -- okay, so 30 basis points, that's within the third quarter alone?

Third and fourth quarter.

Okay, pretty similar over the back half overall.

Yes. A little bit more in the fourth quarter because we open the DC in mid-quarter and finance the New York buying office mid-third quarter.

Okay. And then could I ask you to just provide a little more color on other categories and the regional performance?

Sure. During the quarter, Juniors was the strongest performer. Accessories trailed the chain for us in terms of merchandise categories. Geographically, the Midwest and Mid-Atlantic were the strongest, and Pacific Northwest trailed the chain, due in part to the strong comps in 2013, when they were one of the strongest performing regions.

The next question is from Stephen Grambling with Goldman Sachs.

Just a follow-up on the guidance question. It looks like you are anticipating a bit of a slowdown, it looks like on a 2-year stack basis as it relates to the comp. Is there anything that's underscoring that? Is there anything you can talk to in terms of the comp and traffic trends throughout the quarter and back-to-school?

In terms of the comp trends during the quarter, sequentially, the comps improved as we progressed through the quarter, and July was the strongest month for us, Stephen.

And then in terms of the outlook, Stephen, the comp guidance kind of reflects how we feel. We think the moderate customer continues to be under pressure. We don't see a lot of evidence that, that's going to change in the back half. We could be wrong, but we don't see a lot of evidence of that. And we expect the environment to remain pretty promotional.

And then if I can sneak one follow-up in, just to change gears a little bit. You do have some lumpy CapEx coming up. Is that -- is there any reason, with the interest rate environment where it is, why you wouldn't take on some leverage to fund the distributions, for example?

Yes. So, Steve, we do -- as Michael mentioned, we do plan to take on a little bit of leverage to finance the New York buying office. And overall, as we look at our capital structure, we've looked at various different scenarios, different risk-return profiles. We actually like the flexibility of our current capital structure. It gives us the ability to grow, take advantage of opportunities as we see them. As you know, our first priority has always been investing in the business, investing in the growth of the business and then returning cash to shareholders. And our preference is to return cash to shareholders in more of a planned and deliberate way as opposed to kind of a onetime recap. So that's our view of our current capital structure and taking a little bit more leverage.

The next question is from Lorraine Hutchinson with Bank of America.

I wanted to follow up on the drivers of the higher basket size. Was that a higher ticket or units? And are there any strategies in place to try to continue to drive that basket size higher in the back half?

Lorraine, as we mentioned, the 2% comp was driven by the basket, as transactions were flat. The increase in the basket was mainly driven by units per transaction. AUR was just up slightly.

And in terms of the strategy to continue to grow the basket size, it's really more of the same in terms of improving the assortment, making sure we have great selection of bargains for the customer to take home.

The next question is from Jeff Stein with Northcoast.

Can you tell me how you're planning to finance the buying office and how you arrived at that $2 million interest expense assumption for Q3? And I presume we should just kind of annualize that going forward?

Jeff, yes, you would annualize it, and we haven't discussed how we're going to finance it yet. But it will happen mid-third quarter.

Okay. Can you tell us -- just kind of curious what the average basket size is right now at Ross compared to dd's.

Ross is about 30 and dd's is slightly below that.

The next question is from Oliver Chen with Citigroup.

I had a question about the merchandise margin. It was attractively up. What were the main categories or dynamics driving that? And is your expectation that, that will be flattish for the back half? And just to follow up, if you could talk to us a little bit about how you're thinking about online over the next 3 to 5 years as part of the strategy, that would be great.

Sure. So Oliver, our merchandise margins, the improvement was basically split between higher markup and lower markdown. Now average unit retail, our pricing was flat in the quarter. So that higher markup was really from better buying. That's what drove better markup. And then, obviously, the improved markdowns were from tight inventory control. So those were really the components of it. In terms of online, we actually have quite active program with online marketing, and we don't have [indiscernible] there. We're planning to experiment more with those types of vehicles. In terms of e-commerce, we don't have any plans to get into e-commerce at this point.

Okay. Just the better buying, was that specific to any category? Or was it as a whole in terms of your tight inventory management?

It was broad based.

The next question is from Laura Champine with Canaccord.

When you look at the back half, what's your expectation for freight? Is that pressuring gross margin in the back half? And if so, how much?

So Laura, as [indiscernible] tighten up, [indiscernible], et cetera, we're always seeing some pressure on freight. It's all dialed into the guidance I gave in the back half.

The next question is from Roxanne Meyer with UBS.

I'm just wondering if you can give us an update on just how you feel about your consumer and any changes in behavior between 1Q and 2Q. I mean, it sounds like it's still a tough environment out there, and your consumer is still struggling a bit. But you obviously posted a nice improvement to the comp, but I'm just wondering if you've noticed any patterns in consumer behavior. And secondly, just wondering if you could share any operational initiatives going on in-store that could help drive comps in the back half of the year.

Sure. So Roxanne, I'll take the consumer question and then maybe Gary will answer the operational question. On the consumer piece, we haven't really seen any major shifts from Q1 to Q2. But I think it's pretty apparent that the low- to moderate-income customer is struggling. I think you're seeing that in the -- in some of the results that are being posted by the moderate power [ph] retailers. So I don't think we have anything to add to that other than I think that customer is challenged economically and finding this environment difficult.

So clearly, to drive comps, we need to have great merchandise. So what we do in the stores is make sure that we're efficient, that we're providing the right experience for the customer when she comes in. And some examples of that, we are in the midst of rolling out a workforce management system that should enable us to better schedule at the times that our customer's in the building.

The next question is from Dana Telsey with Telsey Advisory Group.

Can you just -- a brief catch up on some of the components in terms of shrinkage, distribution costs and an update on dd's in terms of what you're seeing there? And lastly, as you think about pricing going into the back half of the year, amount of clearance that you have left over versus last year.

So Dana, why don't I take those out of order. I'll start on your question about dd's. So yes, we were very happy with dd's in the second quarter. dd's posted positive comps and pretty solid profit improvement. I would say, actually, over a longer period of time, that's kind of in the pattern at dd's, that we have good growth. We're seeing good comps and improvement in profitability. I would say that the main reasons for those improvements in profitability have been that dd's is pursuing many of the same strategies that we pursued at Ross in terms of tight inventory control, tight expense, et cetera. So that's kind of the update on dd's.

In terms of distribution, Dana, the -- during the quarter, the DCs delevered a bit as a result. It was mainly related to packaway-related costs. For us, packaway prices and cost are charged the cost of goods sold when packaway is sold. So a decline in packaway levels results in a larger charge to [indiscernible]. In terms of the back half of the year, with the opening of the new DC, you're going to have some deleverage in the distribution centers.

The next question is from John Kernan with Cowen.

Just the off-price leaders, yourselves, TJX and Burlington are opening a lot of doors. How are you viewing the availability of inventory? And just as you become co-located in the same market, there's more and more Maxx stores, how are you viewing this traffic levels in those stores and the productivity levels in those stores?

In terms of store productivity and traffic, actually fine. We -- I should say that in the 33 states that we're in, Marmaxx is in those states, too. So we already compete very successfully with a broad range of retailers. So as we move into new states, there really aren't any additional retailers that we don't compete with today that we'll be up against. It's the same cast of characters.

And in terms of the supply, we're seeing some plentiful [ph] supply, the amount of merchandise in the market.

The next question is from Mike Baker with Deutsche Bank.

All right. So I wanted to ask about the promotional environment. I mean, every retailer who has reported here recently has talked about it being promotional, and I think it is. But I wanted to ask specifically what you're seeing from department stores. And if it is promotional, then it's intriguing that your merchandise margins did so well relative to last quarter. So if you could sort of connect those dots. And then as a follow-up, I think the previous person asked about your expectations for merchandise margins within your guidance for the third quarter. If you could review that, that would be helpful.

As it pertains to promotions in the market, Q2 was a highly promotional quarter, particularly in the mid-tier. And we really don't see any reason for that to change in the back half of the year. In terms of how we got our margins, really, what we do is plan very conservatively, left ourselves liquid, had plenty of open-to-buy, and we chased most of our business. We also had very tight inventory control in this promotional environment, which is key, so that you're always liquid and fluid and you have constant open-to-buy.

In terms of absolute levels, Mike, we didn't break out absolute margins in the back half other than to say it's [indiscernible] the guidance does not show the improvement we saw in the second quarter.

The next question is from Patrick McKeever with MKM Partners.

Question on systems. And just wondering where things stand from a systems standpoint as you prepare to open a couple new distribution centers. Will there be any big changes from a system standpoint? And how -- where are we with micro-merchandising in terms of just the whole benefit cycle?

Sure. So Patrick, on systems with regards to the DCs, there are major new systems that we'll be implementing as we open new DCs. The new DCs will run very similar systems to the systems that are already being used in our current DCs and already fairly mature. So no systems work, I think, with the new DCs. On micro-merchandising, as you know, we've had micro-merchandising in place for 2 or 3 years now. But at the outset, we had said that over time, as the system matures, it will sort of learn from itself and sort of learn from the historical data. And we think we're seeing that. So we think some of the improvements we've seen in certain regions are at least partly due to the micro-merchandising systems and processes that have been implemented.

And then just a quick one on dd's. I mean, it sounds like it's comping pretty well, fairly similarly to the Ross Stores. How about the -- just the bottom line at dd's? Where do things stand from a profitability and return standpoint? Is it still kind of a similar dynamic where dd's is just maybe slightly less profitable than Ross on a four-wall basis?

Well, on a four-wall basis, they're fairly similar. They get there in different ways, but the difference at this point is the leverage of the business and is based on the size of the business and the overhead in the DCs and the other corporate overhead.

The dd's is -- as we said before, Patrick, dd's is accretive to the business, but it's very small, so it really has a minimal impact.

But at some point down the road, it sounds like the concept could be as powerful as the Ross Stores concept, and you could open either one and still have a similar P&L.

Yes, we're very positive about dd's long-term potential.

[Operator Instructions] The next question is from David Glick with Buckingham Research.

Just a question about marketing. As the environment gets more challenging to generate positive traffic, I'm wondering, as you become more national in scope, you're not quite there, but as you become -- have a greater footprint, do you think over time you might make a bigger push in terms of TV advertising or marketing spend in general? Your thoughts on that would be appreciated.

I think our marketing will expand as we geographically, but I don't think it will change radically in terms of its role in our overall business. I mean, our most important priority is to have the best assortments in the stores. And what we find is if we do that, we do business and we actually achieve word-of-mouth marketing from our customer, and that's really the core of the strategy, paid marketing in terms of TV is helpful, but it's not the critical thing.

There are no further questions. I will turn the call back over to Barbara Rentler.

Thank you for joining us today and for your interest in Ross Stores. Have a great day.

This concludes today's conference call. You may now disconnect.