Ross Stores Q2 2023 Earnings Call Transcript

Participants

Corporate Executives

• Barbara Rentler, Vice Chair & Chief Executive Officer
• Adam Orvos, Executive Vice President & Chief Financial Officer
• Michael J. Hartshorn, Group President & Chief Operating Officer

Analysts

• Matthew Boss, JPMorgan Chase & Co.
• Lorraine Hutchinson, Bank of America Co.
• Mark Altshwager, Robert W. Baird
• Chuck Grom, Gordon Haskett
• Paul Lejuez, Smith Barney Citigroup
• Adrienne Yih, Barclays PLC
• Brook Roach, The Goldman Sachs Group, Inc.
• Dana Telsey, Telsey Advisory Group
• Alex Stratton, Morgan Stanley
• Julianna, Wells Fargo & Company
• Marni Shapiro, Retail Tracker
• Laura Champine, Loop Capital Markets
• Edward Yruma, Piper Sandler Companies
• Aneesha Sherman, Sanford C. Bernstein
• Corey Tarlowe, Jefferies Financial Group Inc.
• Chris, TD Cowen
• Jay Sole, UBS Group AG

Presentation

[Operator]

Good afternoon, and welcome to the Ross Stores Second Quarter 2023 Earnings Release Conference Call. The call will begin with prepared comments by management followed by a question-and-answer session. [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, new store openings 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 in the company's fiscal 2022 Form 10-K and fiscal 2023 Form 10-Q and 8-Ks on file with the SEC.

And now I would like to turn the call over to Barbara Rentler, Chief Executive Officer.

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

Good afternoon.

Joining me on our call today are Michael Hartshorn, Group President, Chief Operating Officer; Adam Orvos, Executive Vice President and Chief Financial Officer; and Connie Kao, Group Vice President, Investor Relations. We'll begin our call today with a review of our second quarter 2023 performance, followed by our updated outlook for the second half and fiscal year. Afterwards, we'll be happy to respond to any questions you may have.

As noted in today's press release, we are pleased with our second quarter results with both sales and earnings well above our expectations. Along with easing inflationary pressures, customers responded well to our improved value offerings throughout our stores. Total sales for the period were $4.9 billion, up from $4.6 billion last year, while comparable store sales rose 5%. Earnings per share for the 13 weeks ended July 29, 2023, were $1.32 on net income of $446 million. These results compared to $1.11 per share on net earnings of $385 million in the prior year's second quarter.

For the first 6 months, earnings per share were $2.41 on net income of $818 million. These results compared to earnings per share of $2.08 on net earnings of $723 million in the first half of 2022. Sales to 2023 year-to-date period were $9.4 billion, with comparable sales up 3% versus a 7% decline in the first half of last year. Cosmetics and accessories were the strongest merchandise areas during the quarter, while performance across geographic areas was broad-based. Similar to Ross, dd's DISCOUNTS performance also improved due to better merchandise assortments and the aforementioned moderating inflation.

At quarter end, total consolidated inventories were down 15% and versus last year, while average store inventories were up 4%. Packaway merchandise represented 38% of total inventory versus 41% in the same period of the prior year. Turning to store growth. We opened 18 new Ross and 9 dd's DISCOUNT locations in the second quarter. We remain on track to open a total of approximately 100 locations this year comprised of about 75 Ross and 25 dd's. As usual, these numbers do not reflect our plans to close or relocate about 10 stores.

Now Adam will provide further details on our second quarter results and additional color on our updated outlook for the remainder of fiscal 2023.

[Adam Orvos, Executive Vice President & Chief Financial Officer at Ross Stores]

Thank you, Barbara.

As previously mentioned, our comparable store sales were up 5% for the quarter, driven by higher traffic. Second quarter operating margin was flat compared to last year at 11.3%. Cost of goods sold during the period improved by 185 basis points. Merchandise margin increased 200 basis points, primarily due to lower ocean freight costs. Domestic freight declined 60 basis points while occupancy and distribution costs improved by 20 and 5 basis points, respectively. Partially offsetting these benefits were buying expenses that delevered by 100 basis points mainly due to higher incentives. SG&A for the period increased 180 basis points as higher incentive costs and store wages more than offset the leverage from higher sales. During the second quarter, we repurchased 2.2 million shares of common stock for an aggregate cost of $230 million. We remain on track to buy back a total of $950 million in stock for the year.

Now let's discuss our outlook for the remainder of 2023. As Barbara noted in today's press release, despite the recent moderation in inflation, our low to moderate income customer continues to face persistently higher costs on necessities. As a result, we believe it is prudent to continue to plan the business cautiously. However, given our improved second quarter performance, we are raising our second half sales and earnings outlook. We are now planning comparable store sales for the third and fourth quarters of 2023 to be up 2% to 3% and 1% to 2%, respectively.

As noted in our press release, if the second half performs in line with these updated sales assumptions, earnings per share for the third quarter is projected to be $1.16 to $1.21 versus $1 last year, and $1.58 to $1.64 for the fourth quarter compared to $1.31 in 2022. Based on our first half results and second half guidance, earnings per share for fiscal year 2023 are now planned to be in the range of $5.15 to $5.26 versus $4.38 last year. Incorporated in this updated guidance range is an estimated benefit to earnings per share of approximately $0.16 from the 53rd week in fiscal 2020 rate.

Now let's turn to our guidance assumptions for the third quarter of 2023. Total sales are forecast to increase 4% to 6% versus the prior year. We expect to open 51 stores during the quarter, including 43 Ross and 8 dd's locations. Operating margin for the third quarter is planned to be in the 10.3% to 10.5% range versus 9.8% in 2022 as the benefit from lower ocean and domestic freight costs more than offset an increase in other expenses, primarily related to incentive compensation and store wages. Net interest income is estimated to be approximately $34 million versus $2.8 million last year as we continue to benefit from higher interest rates on our cash balance. The tax rate is projected to be about 25% and diluted shares outstanding are expected to be approximately $337 million.

Now I will turn the call over to Barbara for closing comments.

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

Thank you, Adam.

While we are pleased with our above-plan results in the second quarter, the macroeconomic, geopolitical and retail environments remain uncertain. Moving forward, we remain keenly focused on delivering the most compelling bargains possible as our customer is more motivated than ever to seek the best branded value as prolonged inflation remains an issue. We will also carefully manage our expenses and inventory to maximize our potential for both sales and earnings growth. Longer term, we believe the rigorous execution of our off-price business model will allow us to consistently deliver solid results.

At this point, we'd like to open up the call and respond to any questions you may have.

Questions and Answers

[Operator]

[Operator Instructions] And the first question comes from the line of Matthew Boss with JPMorgan.

[Matthew Boss, Analyst at JPMorgan Chase & Co.]

Great. Thanks and congrats on a really nice quarter. So Barbara, could you just elaborate on the improved value offerings that you cited in the release and just proactive assortment changes that you've made in stores that you think are contributing to the improved performance if any way to speak to trends that you're seeing with traffic versus basket as the second quarter progressed and into August, that would be really helpful.

[Michael J. Hartshorn, Group President & Chief Operating Officer at Ross Stores]

Matthew, let me start on overall trends for the quarter on sequential trends. We wouldn't provide specifics, but I would say comps were relatively strong across the quarter, both on a single year comp basis in a multiyear basis. On the components, as we said in the commentary, traffic was the primary driver of the 5% comp. That was true for both chains. Average basket was flat with an increase -- slight increase in the units per transaction and a lower AUR, which offset the units per transaction.

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

And then, Matt, in terms of the improved value offerings, as we said before, we are really striving to offer better branded value margins to the customer. I mean, our customer is a low to moderate income customer and the merchants have been out there really chasing the business, buying closeouts really looking for compelling, compelling values in bargains, and that's across all areas in the company. It's not just one particular area. It's everywhere because that's really what the customer has been responding to and because the amount of availability of the market, we've been able to do that.

[Matthew Boss, Analyst at JPMorgan Chase & Co.]

Great. And then just as a follow-up, could you expand on gross margin for the balance of this year, meaning how best to think about the opportunity to recapture markdown headwinds that we saw a year ago as the year progresses within merchandise margin. And then just multiyear, are there any structural impediments to returning to pre-pandemic operating margin levels, which I think were in the mid-13s.

[Adam Orvos, Executive Vice President & Chief Financial Officer at Ross Stores]

Yes, I'll take the first piece. Matt, this is Adam. Thanks for the question. Third quarter, from an operating margin standpoint, the components will look similar to second quarter. So ocean freight was a significant tailwind for us will continue in third quarter. But I'll remind you that in fourth quarter last year, we started to see the benefits of ocean freight. So it will moderate considerably in fourth quarter. But again, to answer your third quarter versus second quarter, should be comparable on that standpoint.

From a domestic freight standpoint, again, we commented in the call on 60 basis points of good news, assuming fuel costs stay the same, we'd expect that to continue through the balance of 2023. Other big movers, we've commented a lot about incentive cost. We knew that would be a headwind coming into the year as we outperform this year and go up against an underperforming 2022. So that was a big moving part, and that will continue in the third quarter and fourth quarter, but would also comment the way we flowed incentive costs last year's second quarter was the most impactful quarter. So it'll still be a significant headwind, but in third quarter and fourth quarter, but not as significant as second quarter.

[Michael J. Hartshorn, Group President & Chief Operating Officer at Ross Stores]

Matthew, on the long-term growth algorithm. We still believe we can achieve gradual improvement in profitability over time. In general, EBIT growth, though, will be highly dependent on sustained strong sales growth and certainly how the macroeconomic and geopolitical factors, including inflation may continue to unfold to achieve this, obviously, strengthening our price value offerings across our entire assortment is going to be key to that success. I'd say outside top line, we continue to believe there are opportunities throughout the P&L that can help drive comp growth and EBIT margin expansion over time.

[Adam Orvos, Executive Vice President & Chief Financial Officer at Ross Stores]

And I think you also asked mark down so we didn't answer that question. So given the elevated levels last fall, should expect some benefit as we move through the second half, obviously, assuming we deliver our sales expectations.

[Operator]

The next question comes from the line of Lorraine Hutchinson with Bank of America.

[Lorraine Hutchinson, Analyst at Bank of America]

I wanted to focus on SG&A for a minute. Understanding this year, there's a rebuild of incentive comp. How are you thinking about that line item over the longer term? And what comp would you expect to need to leverage SG&A in the out years?

[Adam Orvos, Executive Vice President & Chief Financial Officer at Ross Stores]

Hi Lorraine, this is Adam. So SG&A, we knew would be pressured due to incentive costs coming into this year, and it clearly was. But most of our SG&A deleverage in the second quarter was driven by incentive costs, although higher store wages played a part in that also. I think your kind of longer-term leverage question, 4% comp is where we think we can clearly lever in SG&A, and that fundamentally hasn't changed for us.

[Lorraine Hutchinson, Analyst at Bank of America]

And then any change to your outlook on wage pressures either for this year or for the coming years?

[Michael J. Hartshorn, Group President & Chief Operating Officer at Ross Stores]

Sure, Lorraine. Generally speaking, wages in our stores and DCs are relatively stable. So there was no change to the outlook for 2023. We continue to take a market-by-market approach to staffing and we do adjust wages where appropriate in individual markets. I say longer term, I think it's going to be dependent on the statutory environment that's really what's driven our wage growth over the last few years.

[Operator]

[Operator Instructions] And the next question comes from the line of Mark Altshwager with Baird.

[Mark Altshwager, Analyst at Robert W. Baird]

Back to the top line for a moment, just with the positive inflection you're seeing in comps, what's your level of confidence that the business can return to a 3%, 3% plus next year? And bigger picture, do you think you've hit the point where the value is resonating in a way that it can trump the inflationary pressure your consumer is feeling elsewhere. I guess, asked another way, tough times is when we would think more customers would need Ross and the trade down can drive the top line. Do you think that's where we are today.

[Michael J. Hartshorn, Group President & Chief Operating Officer at Ross Stores]

Here's how I'd answer that. Generally speaking, we can control what we can control. We know that we made some progress improving our assortments during the second quarter. We also know there's -- we can make significantly more improvements. And with that, I think that gives us confidence that we can continue to grow comp. Longer term, when we start talking about next year, I think we'll be in a better position to see what the outlook is when we give our earnings guidance early next year. So we'll continue to monitor the economy. It still remains very uncertain, and we'll do what we can to offer the customer the best possible value possible in this environment, which is very important to our investment.

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

I think the other piece, Mark, is that if we continue to improve on our value offerings, we really think that, that's the way to gain share across all customer income demographics. So if we do a good, better, best strategy, and we have incredible values, we have more of an opportunity to gain more customers.

[Operator]

Our next question comes from the line of Chuck Grom with Gordon Haskett.

[Chuck Grom, Analyst at Gordon Haskett]

Can you guys hear me?

[Adam Orvos, Executive Vice President & Chief Financial Officer at Ross Stores]

We can.

[Chuck Grom, Analyst at Gordon Haskett]

I wanted to see if you guys are talking about the home category a little bit. You called out cosmetics and accessories being areas of strength, your largest peer, the day you talked about home being strong. And I was wondering if you could talk about that and also tie in what's happened with the path.

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

I'm sorry. I think as the last piece you said, with?

[Chuck Grom, Analyst at Gordon Haskett]

You could just tie in any benefit you think you saw in the quarter and could expect to see in the coming quarters from bath and beyond.

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

From bath and beyonds. Okay, sorry. Home also performed above the chain average. And so we feel that there's a lot of growth still left in home for us, pretty broad-based across the board. In terms of Bed Bath & Beyond, two thoughts. One is that they lost a lot of volume prior to the event happening and the classification that they carried where we have overlap. I think over time, we could pick up more volume perhaps, but I think that's very hard to measure. And you have to have overlap of the locations. So I think there's some opportunity how to measure that. I'm not really sure how to measure it. I think of it more as a total home package. We feel like we have a lot of growth in home still ahead of us. And again, I think that's pretty broad-based.

[Chuck Grom, Analyst at Gordon Haskett]

And just as a quick follow-up. Do you like the home category is starting to form a base after several quarters now of attrition?

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

You mean specifically to us or you mean in the world.

[Chuck Grom, Analyst at Gordon Haskett]

I guess both because it seems like more people are talked about the home category starting to form the bottom.

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

Yes. Look, I think it depends on where you are in your development of the home business. So we have some businesses that are more developed than others. And so I think as we develop some of those other businesses, it will help us to continue to grow that as opposed to if we were in every business and everything was developed. So all businesses within our home business are not created equal. And so I think, Ross, we still see opportunity. In terms of the outside world, yes, there are a lot of people in home, and it goes back to what you're offering. So if I take the whole value equation for us in the entire box that would include home and making sure that we have the right values to continue to grow that business and then to maximize the areas where we are still what I would call underdeveloped.

[Operator]

And the next question comes from the line of Paul Lejuez with Citigroup.

[Paul Lejuez, Analyst at Smith Barney Citigroup]

Curious how dd's performed relative to Ross. I think you said you saw improvement at both. But curious on an absolute basis how dd's performed. I think it's been underperforming for about a year now. And so also curious if you think that underperformance continues or perhaps do easier comparisons cause dd's to start to outperform the ROS concept just whatever is built into your assumption?

[Michael J. Hartshorn, Group President & Chief Operating Officer at Ross Stores]

Paul, I would say, as we mentioned in the commentary, dd's performance also improved during the quarter versus first quarter, and we believe that's a combination of better assortments and like Ross moderating inflation. That said, dd's sales trends continued to trail Ross. As a reminder, the dd's average household income is more impacted by the inflation, especially on necessities, their average household income is 40,000 to 45,000 compared to 0 to $65,000 for Ross. Our strategy here is very similar. We are very focused on offering strong values, which is very important to the dd's customer today.

[Operator]

And the next question comes from the line of Adrienne Yih with Barclays.

[Adrienne Yih, Analyst at Barclays]

Great. Thank you very much. Barbara, I wanted to ask you about the packaway merchandise. I mean, a shade lower than last year. I was just wondering if you can talk about how much of that packaway is actually short stay intra-season versus kind of annualized, I know you tend to do more of the short stay. And then the supply chain sort of being unlocked. Obviously, I would assume that, that allows you to play in that kind of short stay much more effectively. My second just follow-up question is -- on the direct import side, you don't do as much direct imports. So I'm just curious how much of the ocean -- sort of the model mix ocean to air versus domestic, right? So is that outbound, I suppose, rail trucking. Is that rail trucking the domestic portion of it outweighing the ocean air, if I could ask that. Thank you very much.

[Michael J. Hartshorn, Group President & Chief Operating Officer at Ross Stores]

I'll answer the question on the transportation. Ocean freight, despite the fact that direct imports is a smaller part of our business, Ocean Freight had a larger impact than the domestic transportation save. The domestic transportation, you can see it separately within our gross margin was driven by better rates, but within the year, fuel rates have come down versus our expectations, which is where we saw a benefit in the first quarter -- or second quarter, sorry.

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

And then in terms of short stays of packaway, it means the mix of what we would define or guess what you're defining as longer stay versus short stays of product. And that very much depends on when you're buying, right? So if you're buying bring packaway for next year, that would be something that would be happening more along the lines of this -- kind of this time frame. So again, so there's always a mix and it fluctuates based off of what we find, what we want to pack, what that looks like.

So there's no formula to that. It's really about what's the best possible deal, that possible value we can get for the customers. So that moves around. But it is a combination of both. And at this particular time, it's kind of like you haven't necessarily put out all your call, and you haven't necessarily put in all your spring if you were talking on the apparel side. The supply chain unlock in terms of a short stay in the hotel, are you implying on our direct imports or you're applying in the outside world?

[Adrienne Yih, Analyst at Barclays]

In either. Probably both, if you can share that?

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

Yes. So the short stays in terms of putting in the hotel, we don't necessarily put goods that we bring in ourselves in the hotel in any big way unless we have to. Now a year ago, when we handle the carrier issues. Obviously, the goods arrived early. We took the goods in, we released them. Sometimes we do -- we put goods in there for short stays for a variety of reasons. Container side, there's a variety of reasons why we do it. But it's not something that we like to do as a big -- as a large strategy in home with our own imports, but we do, do some. So the supply chain timing of the unlock for, I'll call it, business as usual prior to the casual, the carrier issues. Again, we manage that very closely. It really was last year in this time frame where all those goods came in, we had to put it in and then metered out at the appropriate time for the customer. Otherwise, we would have been off seasonality and a variety of other issues along with that.

[Operator]

And the next question comes from the line of Brook Roach with Goldman Sachs.

[Brook Roach, Analyst at The Goldman Sachs Group]

Barbra, you talked about the opportunity to continue to improve your assortment as you move forward following some early gains. Was there any change in your mix this quarter between good, better, best. And how are you planning those buys between the assortment of good, better, best into the second half of the year?

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

Change in good, better, best. I don't really think there was a significant change in our good, better, best strategy. Best has been out there in the market a while. There's been a lot of availability. So a lot of what -- for this past quarter that would have affected what you would have seen on the floor in terms of the three buckets was the amount of merchandise that we chased and the availability in the market. And so since the availability in the market is pretty broad-based between good, better, best, I mean, as usual, not every class, every price point. I think the assortments are more reflective of what we've been able to chase. And I would say the same thing for fall. Obviously, we have a strategy around balance.

But when you're chasing as much as we're chasing, that kind of really goes to what the customer is voting on, and what we can get in the market. And I think the merchants in Q2 did a very good job of getting values on the floor, chasing back into more of what you wanted and trying to hit the appropriate the appropriate levels of each one of those buckets because the customer votes every day. So we could want a particular good, better, best on the floor. That's not necessarily what the customer wants. So I think the merchants have really been out in the market and really, really looking for great deals, which have been out there. And so it fluctuates. And I would expect it would fluctuate in Q3 and Q4. But we are looking for each one of those buckets and great deals in all of them.

[Operator]

And the next question comes from the line of Dana Telsey with Telsey Advisory Group.

[Dana Telsey, Analyst at Telsey Advisory Group]

Good afternoon everyone and nice to see the nice results. As you think about the current environment, I believe last time, Barbara, you had mentioned the focus on value that the consumers are searching for and you could do a better job of it. How much is the improvement that we saw this quarter? Is the comparison given the increase in traffic, how much of it was the consumer? And how much of it on your journey of better value for better brands? How much of it is your progress there? And where are you versus relative to where you want to be? And then just any updates on new store productivity levels how those are doing versus your plan?

[Michael J. Hartshorn, Group President & Chief Operating Officer at Ross Stores]

Dana, on the productivity levels, they haven't changed. They've averaged between 60% and 65% of average mature store for the chain, and that has not changed over time. Traffic. So on traffic your question on traffic. So traffic was the main driver of the comp for the quarter.

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

And where is the customer on the journey. Look, I think the customer with moderating inflation is feeling a little bit little bit more room to spend money. But again, our customer is moderate to low income customers. So they still -- they still faces inflation in front of her because she has just the higher cost of the necessity she has to spend. So I think on our journey with the customer in terms of better value and better values on the floor, I think it's a continual process, right? The customer votes and the merchants are out buying goods and responding to what she's voting on. So I think from -- in second quarter versus first quarter, I think the merchant team did a better job of offering her broader assortments and better values.

And I think we'll continue to make progress on that, and it will seek at some level. It's not really a target or a level that we have in mind. It's just how the customer responds. And obviously, we want to put out the best possible values we always can. And so the merchants have that mind and now they have really heightened awareness and the ability to chase goods has really given us an opportunity to perhaps accelerate some of those things. So again, it will continue. I don't have a beginning or an end amount that we think you should ask because I think the customer will decide for us and our job and the merchant team's job is to respond to that and satisfy her on whatever level that is.

[Operator]

And the next question comes from the line of Alex Stratton with Morgan Stanley.

[Alex Stratton, Analyst at Morgan Stanley]

Congrats on a nice quarter. I wanted to talk about the competitive landscape. On our end, we've witnessed the rise of these low-priced e-commerce players in recent years like even Shein. So I'm just wondering like how maybe Barbara, you think about those types of businesses, what they mean for Ross or even how the competitive landscape has changed now versus a few years ago?

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

Sure. Well, obviously, Shein's doing a lot of business, and they offer great value. We have a -- our junior business is a pretty large business for us in ladies apparel. So I think that would be most comparable. I don't think I can really compare myself to Shein. I think the reality of it is there's a lot more competition in that arena, whether it's them, whether it's Primark, whether -- so I think it's just our job to be able to offer assortments that satisfy the customer. And again, they're just like another competitor.

In terms of -- if you think about all the competitors, right? Department stores years ago had a lot more share so that would have been a major competitor for us. I think -- I mean, you would know better than I would know your you're watching the world evolves and different segments of the market are more challenging than others. And so I think one of the best parts about being in off-price is that we have a unique opportunity to satisfy all types of customers. This is why we want the assortments to be broad. This is why we want the values to be strong. And everyone keeps asking about the trade down customer. I think just getting more customers is really by broadening your assortment. And I think off-price has a unique opportunity to do that, versus if I mean, another particular segment.

So if the merchants obviously study Shein, they study all the other retailers and their job is to understand what they are and what we can offer and to give the best product and the best value that we can. And I think there's been -- if we looked at this and had this discussion 10 years ago, it would be a very different discussion than where we are today. So retailing is -- I think we probably all agree dynamic. And so -- but I do believe that off-price has this unique opportunity because it carries lots of products, and it has the ability to flex based off of the customer and you're not kind of pigeon hold into one view of who you are, you can flex and move with what the customer wants. So I think off-price is in the right place at the right time.

[Operator]

And the next question comes from the line of Ike Boruchow with Wells Fargo.

[Julianna, Analyst at Wells Fargo & Company]

This is Julianna on for Ike. Congrats on a good quarter. Maybe just a quick follow-up on AUR. Is the moderation we're seeing there more a result of mix shift towards cosmetic and accessories. For example, we saw this quarter. And as we see on performance improving, do you see that driving an upside there?

[Michael J. Hartshorn, Group President & Chief Operating Officer at Ross Stores]

On the AUR, it was a combination of mix shift and us providing better values to the customer. The way we think about it going forward is we really don't plan the business on traffic or transactions. We think if we offer the best values that will have an impact on both traffic and basket size. AURs will fundamentally be dependent on the mix of sales in the business.

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

And in terms of home, listen, I feel like we -- what I said, we have opportunity in home. And so that compared to the company is there are upside versus other businesses. I think, over time. Home is not -- home is longer lead time type businesses and things, but I do believe there is upside.

[Operator]

And the next question comes from the line of Marni Shapiro with Retail Tracker.

[Marni Shapiro, Analyst at Retail Tracker]

Congratulations on a great quarter. I'm curious, in most of your regions or a lot of your regions, students are back-to-school. I'm curious if you saw early pickup for traffic for back-to-school and what the trends were looking like? And just in general, I'm curious if you guys are seeing sort of the peaks and valleys in your traffic around holidays where holiday weekends or holiday events, the traffic is much higher. And when it's in the valley, it's lower? Or has it evened out a little bit?

[Michael J. Hartshorn, Group President & Chief Operating Officer at Ross Stores]

Hi, Marni, we wouldn't talk about intra-quarter trends for back-to-school. In terms of traffic, I would say in our business, it's been very steady versus peaks and valleys that you mentioned.

[Operator]

And the next question comes from the line of Laura Champine with Loop Capital Markets.

[Laura Champine, Analyst at Loop Capital Markets]

I noted that this was the third quarter in a row of inventories down double digits, which seems just to be normalization, but -- do you have enough inventory in your opinion, given the current improvement in sales trend?

[Michael J. Hartshorn, Group President & Chief Operating Officer at Ross Stores]

Laura. Yes, the reduction in inventory was down 15%, as we mentioned in the release, and that was really about the comparison versus last year where we had as Barbara mentioned, substantial amount of early receipts that we had to store in our packaway facilities and also higher end transit inventory. So we're up against those larger numbers last year. We feel good about our overall inventory levels. We actually ended up 4% in our stores. So I would say, overall, the level and content of the inventory we're happy with.

[Operator]

And the next question comes from the line of Edward Yruma with Piper Sandler.

[Edward Yruma, Analyst at Piper Sandler Companies]

Just quickly, I know you cited strength in cosmetics and accessories. Kind of curious on inventory availability there if you're chasing there. Obviously, there's a proposed M&A in this space, would that impact, in your opinion, kind of accessory availability long term. And then just a model housekeeping question. I noticed that accrued payrolls were up pretty materially year-over-year and sequentially. Any driver you'd like to call out there would be great.

[Adam Orvos, Executive Vice President & Chief Financial Officer at Ross Stores]

On the last piece, accrued payroll, it's really our financial performance. So incentive costs are up. And when you look at that this year versus last year comparison.

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

And I just want to make sure on the cosmetic and accessory question, you want to know what the availability is?

[Edward Yruma, Analyst at Piper Sandler Companies]

Yes. Just kind of curious if you're seeing good product in the market and if you're willing to opine on this M&A that may happen in the space, like would that hamper your availability in accessory space longer term?

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

Look, there's availability in almost every market, as I said in the beginning, I mean, not every class in every business in every market have availability, but both cosmetics and accessories have availabilities just depending upon what it is you're looking for. The second piece of the question, I'm not sure.

[Michael J. Hartshorn, Group President & Chief Operating Officer at Ross Stores]

We wouldn't comment on the M&A in the market.

[Operator]

And the next question comes from the line of Aneesha Sherman with Bernstein.

[Aneesha Sherman, Analyst at Sanford C. Bernstein]

So similar to last quarter, your new guidance also model a comp acceleration on a 4-year stack. Can you talk about what makes you confident about that acceleration going into the second half? Is it more about external factors like inflation moderating? Or is it about internal execution and bringing a better product to the market? And then second, some other discount retailers have talked this week about absorbing inflation and doing price rollbacks for back-to-school. Do you expect fall and back-to-school to become quite promotional across the sector?

[Michael J. Hartshorn, Group President & Chief Operating Officer at Ross Stores]

On the guidance, Aneesha, I think it's a function of how we performed in the second quarter and our confidence in the assortments we're providing the customer. I'd say that's what's driving our guidance in the third quarter. In the fourth quarter, we actually see a deceleration, and we'll update that as we get closer. We think the fourth quarter could be a very promotional holiday season.

[Operator]

And the next question comes from the line of Corey Tarlowe with Jefferies.

[Corey Tarlowe, Analyst at Jefferies Financial Group]

You talked about cosmetics and accessories and a little bit on home. I was wondering if you could also touch on footwear and apparel, anything you're seeing there, how did that perform relative to the chain average. And then just on real estate, what's the availability look like? And is there any impact that you're seeing as you look down your real estate pipeline in terms of the impact from potentially higher rates on higher interest rates on either rental agreements or returns that you're seeing?

[Michael J. Hartshorn, Group President & Chief Operating Officer at Ross Stores]

Sure. Merchant-wise, let me talk about the category performance. Merchandise-wise, cosmetics and accessories, as we mentioned, we're again the best performing businesses. Shoes and Home were above the chain average. Apparel trailed the chain, although it performed above our plan and improved versus Q1. On real estate availability, I'd say, overall, there's been an increased interest from other retailers and the types of real estate that we typically prefer. That said, our team has a very methodical process of developing a healthy real estate pipeline to support our long-term growth plans. And in terms of rent, obviously, we're under contract and have option renewals, and we're not seeing, at this point, major increases in our rent costs.

[Operator]

And the next question comes from the line of John Kernan with TD Cowen.

[Chris, Analyst at TD Cowen]

This is Chris on behalf of John. Just given the still broadly highly promotional environment across retail heading into the second half, in your sharper value proposition. I wonder if you could just talk to you rather broadly or directionally, how you see sort of your merchandise margin in relation to your Q3 operating margin guidance

[Adam Orvos, Executive Vice President & Chief Financial Officer at Ross Stores]

Chris, merchandise margin will continue to be primarily driven by ocean freight benefit. I mentioned earlier, we'll have a little bit of tailwind just from as we had elevated markdown levels, that will be helped to us. And really, that's all we see as major moving components within merchandise margin.

[Operator]

We have time for one final question coming from the line of Jay Sole with UBS.

[Jay Sole, Analyst at UBS Group]

I guess if you just take a step back and just give us an idea of how the overall inventory buying environment compares right now to a year ago? Because if you go back a year ago, it was really a time where a lot of retailers and just the whole industry realized how much excess inventory had been built up post reopening and taking sort of the slowdown as inflation really started to kick in. So could you just give us an idea of how you think about the environment now relative to them? Is it as good? Is it better? Is it a little bit worse at a lot worse? Any kind of context there would be helpful.

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

There was a lot of availability last year, and there's a lot of availability now. And again, it's broad-based, obviously, again, not every single classification of business. But there is definitely supply was there last year and it's there again this year.

[Operator]

There are no further questions at this time. I'd now like to turn the floor back over to Barbara Rentler for any closing comments.

[Barbara Rentler, Vice Chair & Chief Executive Officer at Ross Stores]

Thank you for joining us today and for your interest in Ross Stores.

[Operator]

[Operator Closing Remarks]