Ross Stores Earnings: Value Basics Drive Traffic, Allowing for Expense Leverage, but Shares Lofty

Like its peer TJX, narrow-moat Ross Stores ROST put up a strong second-quarter performance despite the inflationary environment increasingly holding lower-income consumers hostage. In the period, sales rose 8%, bolstered by 5% same-store sales growth that handily outperformed our flat forecast. Moreover, due to lower-than-expected expenses, Ross was able to hold its operating margin flat year-over-year at 11.3%. Like narrow-moat TJX, lower freight costs allowed for gross-margin expansion for Ross; it achieved a 27.7% rate, around 190 basis points better than last year. It is apparent to us that the value proposition that Ross offers is attracting strong customer traffic, a key support for its sales growth. Further, this momentum is set to continue into the third quarter: Ross offered a forecast for 2%-3% same-store sales growth, a 10.3%-10.6% operating margin (implying 60 basis points of expansion), and $1.16-$1.21 in EPS (20% increase). As such, we plan to lift our second-half outlook towards the firm’s updated range, which will lead us to roughly $5.20 in fiscal 2023 earnings, squarely in the $5.15-$5.26 range that Ross now anticipates.

However, these changes only increase our $103 fair value estimate by a mid-single-digit percentage, rendering shares rich. With Ross trading at around $120, representing nearly 22 times 2024 earnings, we believe shares are overvalued. In the near term, we expect Ross to continue to benefit from a cautious consumer that has been plagued by higher-than-usual inflationary conditions, driving a necessary shift to off price. But, over the longer term, we expect demand patterns to normalize, leading Ross to average annual growth of 3% same-store sales (in line with the 4% over the past 10 reported years), annual sales growth of 5%, and a 13% terminal operating margin. Even with more moderating growth ahead, Ross should be able to deliver impressive ROICs that average 27%, well ahead of our 9% weighted average cost of capital estimate.