The Q1 Earnings Season for the retail sector (XRT) has begun, and the results have been disappointing. In addition to Target (TGT) and Kohl's (KSS) reporting a slowdown, Ross Stores (NASDAQ:ROST) saw net sales decline 4% year-over-year despite a much higher store count. This prompted the company to reel in its FY2022 guidance, no longer projecting EPS growth this year. The good news is that this has improved the stock's valuation, but at $79.50 per share, I don't see any reason to rush in and buy the stock. Instead, I would be looking for a re-test or undercut of the post-earnings low to bake in a larger margin of safety.
Just over four months ago, I wrote on Ross Stores, noting that there were much better bets elsewhere, with the stock trading at its historical earnings multiple in a period where it made sense to use more conservative multiples due to headwinds faced by retailers. Since then, the stock has slid 30%, coming off a rough earnings report with a massive top-line miss. The good news is that this has improved the stock's valuation. The bad news is that the stock has sliced through a multi-year uptrend line, suggesting that sharp rallies toward the $90.00 and the underside of this uptrend line may run into strong selling pressure ($97.00-$99.00).
Ross Stores released its Q1 results last week, reporting quarterly revenue of ~$4.33 billion, a 4% decline from the year-ago period. The softness in the period was not overly surprising given that it had to lap the benefit of government stimulus in Q1 2021 and pent-up demand from consumers to refresh their wardrobes. Still, the sales performance was well below management and analyst expectations, and the company admitted that it could have executed better in the period than it did.
The company noted in its prepared remarks that the slowdown was broad-based across categories and that higher average baskets were offset by a decline in transactions from the prior year. Across the business, dd's Discounts performance was softer than that of Ross Stores, with the average shopper at dd's having a much lower average household income (~$45,000 vs. ~$65,000), with inflationary pressures putting a much larger dent in the wallets of dd's shoppers.
Given the persistently elevated inflation readings (April: 8.3%), this shouldn't be a huge surprise, with higher gas and food prices putting a severe dent in demand for discretionary items, and these trends do not appear to be improving. Combined with softer operating margins due to higher ocean freight, distribution, and domestic freight costs, Ross Stores is guiding for quarterly earnings per share of $1.03 at the mid-point in Q2, representing a 26% decline from the year-ago period. Meanwhile, the company is guiding for same-store sales to decline 5% at the mid-point vs. 15% in the year-ago period, and a 7% decline in Q1 2022.
While the sales performance left a lot to be desired, the margin performance wasn't any better, with merchandise margins down 170 basis points year-over-year and operating margins sliding from 14.2% to 10.8%. It's worth noting that merchandise margins would have been flat if not for the headwind of higher ocean freight costs. The silver lining is that we may be seeing a short-term peak in fuel prices, even if they will remain elevated, assuming the conflict in Ukraine doesn't worsen. In addition, while supply chain headwinds are putting a dent in margins, this also should normalize at some point, allowing Ross Stores to claw back some of its margin losses.
The other good news is from an earnings per share standpoint, and this is the fact that Ross Stores is getting an unusual opportunity to buy back a significant amount of its float at relatively depressed prices. While the company's timing wasn't great, buying back 0.7% of the float in Q2 at prices near ~$96.00 per share, the company has $950 million available for share repurchases and could buy back more than 12 million shares at current prices, or nearly 4% of its float. While this won't provide much of a benefit in 2022, it will significantly reduce the share count next year, allowing for growth in earnings per share.
While the inflationary pressures, slightly higher inventory, and what looks to be a weaker consumer are not ideal, Ross Stores has not abandoned its growth plans and remains confident in its business model long term. In fact, the company opened 30 stores in Q1, including 22 Ross Dress For Less stores and eight dd's Discount stores. The company is on track to open 100 stores this year, representing nearly 5% unit growth vs. 2021 levels. In fact, the company noted that it believes there are market share opportunities and that value will become increasingly important to the consumer in this challenging environment.
Given that Ross Stores is sticking to its previous unit growth outlook and could buy back nearly 5% of stock this year depending on where share repurchases are executed, this should set the company up for new all-time highs in annual EPS in FY2023. Obviously, the preferred earnings growth is generated from positive same-store sales combined with unit growth, not a lower share count due to buybacks and unit growth. Still, although earnings will contract in FY2022, assuming things don't improve, this should be merely an aberration in the long-term earnings trend. Let's take a closer look below:
The chart below shows that Ross Stores has seen solid earnings growth since 2014, with annual EPS increasing from $4.56 in FY2019, representing a 15.8% compound annual EPS growth rate. While COVID-19 led to a temporary detour from this previous trend, Ross bounced back strongly in FY2021, reporting another record year for annual EPS ($4.87). Under previous assumptions, annual EPS was expected to climb to $5.30 in FY2022 and increase to $5.85 in FY2023, maintaining a low double-digit compound annual EPS growth rate (11.5%). However, these estimates have had to be revised significantly lower following the rough Q1 report.
As it stands, Ross is now expected to see earnings decline to below FY2019 levels ($4.51 vs. $4.56), and while annual EPS should hit new highs in FY2023, estimates have been cut by more than 12% ($5.14 vs. $5.85). While it's encouraging that the company could see annual EPS recover sharply next year, assuming supply chain headwinds are finally in the rear-view mirror, this has put a major dent in the company's earnings growth rate. In fact, if Ross Stores just meets estimates ($5.14), its compound annual EPS growth rate will dip to 9.9% from estimates of 11.5% previously, and a compound annual EPS growth rate of 15% over the past two decades.
At first glance, investors might conclude that Ross Stores is dirt cheap, given that it has historically traded at 20.2x earnings and the stock currently trades at 15.5x FY2023 earnings estimates at $79.50 per share. However, I would argue that with a lower earnings growth rate and multi-decade high inflation readings, we should be using a more conservative multiple to find the fair value for the stock. Based on what I believe to be a more conservative earnings multiple of 18 (10% discount to historical multiple) and FY2023 earnings estimates of $5.14, I see a fair value for the stock of $92.50.
From a current share price of $79.50, a fair value of $92.50 translates to 16% upside, or closer to 18% upside on a total return basis when including the dividend yield (1.6%). However, when starting new positions in large-cap names, I don't only want upside. I want a meaningful margin of safety relative to what I believe to be conservative fair value. After applying a 25% discount to conservative fair value to bake in a margin of safety, the low-risk buy zone for Ross Stores comes in at $69.40 per share. At these levels, the stock would trade at less than 14x forward earnings, and much of the recession risk would be priced into the stock. Let's move on to the technical picture:
Looking at Ross' monthly chart above, we can see that the stock broke a multi-year uptrend line during its recent correction that extended all the way back to 1995, connecting the 1995 and 2008 lows. Often, support breaks of this magnitude can lead to very sharp moves lower and often require a significant period of base building to allow the stock to start new intermediate-term uptrends. For this reason, I would not expect a V-shaped recovery in the stock, and I would not be surprised to see a re-test of the recent low at $69.75 in the coming months.
Some investors might be quick to point out that this uptrend line also was broken in March 2020, and the stock went on to hit new highs just one year later. While this is true, the uptrend line break in March 2020 did not register on a monthly closing basis, but it will unless Ross Stores can reclaim the $99.00 level before month-end, which looks highly unlikely. Given this negative technical development, I don't see any reason to rush in and buy the stock here above $79.50 per share.
If we take another look at the stock's weekly chart, we can see that prior support at $96.00 is now likely to become strong resistance. This is because many investors who accumulated at this prior support area may look to exit their positions at breakeven or near breakeven after suffering a 25% plus drawdown. Meanwhile, the next strong support level doesn't come in until $66.25. Generally, I prefer at least a 5 to 1 reward/risk ratio from a technical standpoint to justify starting new positions in low-growth names. Given that ROST has $17.00 in potential upside to resistance and $12.75 in potential downside to support, ROST doesn't meet these requirements just yet.
Having said that, if the stock were to decline below $70.00, where it would have $4.00 in potential downside to support and $26.00 in potential upside to resistance, this would set up a low-risk area to start a position in the stock. Obviously, there's no guarantee that the stock will dip this low, and there's a risk of waiting for lower prices to start a position. However, given the multi-decade uptrend line break and what should be another underwhelming quarter for the company, I don't see any reason to pay up for the stock, and I would only consider starting a position at or below $70.00 per share.
Ross Stores had a rough Q1 report, and it's no surprise that the stock has reacted so sharply to the downside following the significant changes to annual guidance. While the hit to consumer wallets is not ideal, Ross Stores has weathered recessions in the past and could see a trade-down effect if inflationary pressures persist. Hence, while we could see the stock in the penalty box medium-term with lukewarm Q2 guidance, I don't see any change to the long-term picture. Given Ross Stores' strong track record and improving valuation, I would view pullbacks below $70.00 as buying opportunities.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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