American Eagle Outfitters - Earnings Call - Q2 2012

Transcript

Speaker 7

As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Judy Meehan, Vice President of Investor Relations. Thank you, Ms. Meehan. You may begin.

Speaker 5

Good morning, everyone. Jim O'Donnell, Chief Executive Officer, is joining us by phone today. Here in Pittsburgh, we have Roger Markfield, Vice Chairman and Executive Creative Director, and Joan Hilson, Executive Vice President, Chief Financial Officer. If you need a copy of our second quarter press release, it is available on our website, AE.com. Before we begin today's call, I need to remind you that during this conference call, we will make certain forward-looking statements based upon information which represents the company's current expectations or beliefs. The results actually realized may differ materially from those expectations or beliefs based on risk factors included in our quarterly and annual reports filed with the SEC. I'd like to turn the call over to Jim.

Speaker 4

Thanks, Judy. Good morning, everyone. I will begin with an overview of our second quarter performance, which will include an update on each of the brands as well as AEO Direct. Next, I will turn it over to Roger to share his perspective on design and merchandising, and then we'll conclude with a financial review and an outlook from Joan. As we all know, the lack of economic recovery has created a persistently challenging retail environment. That said, we managed our business prudently and made progress on our longer-term initiatives. I'm pleased to report our second quarter sales increased 4%, demonstrating improvement from the first quarter, and our EPS of $0.10 was within the range of our expectations. During the second quarter, we began our strategy to maximize key item businesses like denim and shorts with stronger and more impactful promotions.

This strategy, combined with ongoing merchandise improvements, is driving improved results. Although comparable store sales were flat, they were consistently and certainly stronger than the previous few quarters. Performance was fairly consistent within the AE brand. Both men's and women's comps were flat, which is a positive sign for women's business. Overall highlights of the quarter include AEO Direct, which increased 16%, and Aerie standalone stores demonstrated stronger margin results. Overall, though, our promotional activity was planned and well controlled. However, as expected, higher cotton prices pressured margins and will continue to do so in the second half of the year. There are several indications that the cost of cotton is stabilizing. If that's the case, there is opportunity to recoup a good portion of the margin that we lost and we recovered in 2012. Expense management efforts continue to pay off with SG&A leveraging in the quarter.

As Joan will review in greater detail, we're moving into a second phase of our profit improvement initiative, which also includes a deeper dive into a real estate initiative as well as other ongoing expense savings. Our balance sheet remains exceptionally strong with more than $500 million in cash and investments at the end of the quarter, and we continue to use our cash to invest in the business. This brings me to growth. There's no doubt we are focused on managing the expenses, but at the same time, we still have our sights set on growth. Earlier this year, we laid out a series of key initiatives to move us towards that goal. Here's a brief update. Within the American Eagle brand, we are capitalizing on the strength of the brand and our continued dominance in key categories, as I mentioned earlier, such as denim.

Beginning with Back to School, we have made bolder investments designed to win back market share. This customer is still highly focused on price, and yet we are deliberate in our promotional activity. By investing in proven businesses, offering powerful everyday value, and creating excitement with compelling promotions, we believe we'll continue to drive strong top line. Our merchandise investments include a strong focus on AE jeans, as denim is obviously a critical driver for the Back to School business and fall. We've increased inventory to support demand, particularly in styles that carry through holiday and as well into the spring season. We've also made an important investment in accessories, where we see significant future opportunity. The response has been encouraging, particularly in women's, and we are excited about its potential.

At quarter end, we had 250 accessory shops within the American Eagle stores, and we expect to have 400 of these shops by holiday. Also new for AE this holiday, we plan to launch a comprehensive American Eagle personal care line for both men and women. As I mentioned earlier, AEO Direct had a very strong quarter. We continue to build this business and see it as a great growth vehicle. During the quarter, AE.com was updated with a fresh look and functional upgrades to enhance the shopping experience. Improved navigation features and new filter options made it easier to shop at the category level, and we made key upgrades to the search function as well. As a result, we're seeing increases to our already strong conversion rates. Now for a few details on our portfolio brands, beginning with Aerie.

As you know, we've been expanding this business into a more complete lifestyle brand. While it's still early in the process, I'm pleased to see the second quarter margins show further improvement. Additionally, the initial response to Aerie's fall line has been quite positive. We're seeing increased traffic as well as a positive customer response to the merchandising. Aerie's intimate apparel offerings continue to build on its success with additional bra launches in the fall. We're also focused on increasing overall brand awareness with a comprehensive advertising campaign that includes television, print, and mall advertising, as well as an innovative social media program. Turning to kids, this brand continues to gain momentum with a growing customer base and a higher awareness overall. During the quarter, we opened six stores, bringing the total to 21 77 Kids' locations. This included the launch of 77 Kids in our Times Square flagship location.

77 Kids continues to show significant potential. The brand is led by a dynamic and highly creative team with a true passion for delivering the best shopping experience, not only for moms, but for the most discerning customers, the kids themselves. On the international front, we are growing the American Eagle Outfitters' presence in several markets. Following our entrance into Hong Kong earlier this year, we have opened four new franchise stores in Kuwait, Dubai, China, and Russia. We're planning to have a total of 21 international stores open by year end, including new locations in Dubai, in Lebanon, Saudi Arabia, Morocco, Jordan, and Egypt. We're also driving global growth in AEO Direct by adding local currency options, as well as customized language features. In closing, we're making significant progress in a number of important areas.

However, given the continued uncertainty around the macro environment, we have tempered our outlook for the second half of the year. While Back to School has gotten off to a terrific start, we're facing lower customer confidence in spending, especially during non-peak selling periods. With this in mind, we're being aggressive and highly targeted on pricing and promotional activity and merchandising. The American Eagle brand has a loyal and large base. We're focused on maximizing our share of their wallets, as well as expanding our reach to new customers in the mall, as well as the web. Now I'll turn it over to Roger. Thank you.

Speaker 0

Thanks, Jim, and good morning, everyone. There is no doubt we would have liked to have achieved stronger financial results, but we held our own in a highly competitive and promotional environment. I was pleased to see second quarter sales improve nicely from the first quarter as we began to transition toward a more comprehensive key item strategy and stronger fashion content. Supported by investments in core AE categories, we can accelerate our business through strategic and targeted promotions. In other words, we now have the flexibility to go on offense. With a more balanced inventory position, we are seeing a positive change in our business. We are the main highway for the 15 to 25-year-old, and we strive to be top of mind every day.

We are 100% focused on providing the right styles, great quality at the right price, and also having the best overall customer experience, both in stores and online. Across the AE brand, we continue to have terrific success in denim where we are the number one with our customer base. We are now in a much better position to support replenishment and satisfy demand. This is especially true in core denim styles, which have greater longevity. Essentially, to drive denim 12 months a year, we are positioning core styles to live through the spring season with fashion styles flowing more frequently. This change has had a positive impact, with denim continuing to perform well during the Back to School season. This summer, we saw a strength in shorts and pants and continue to be a strong bottoms brand for our demographic.

In tops, we are focused on getting the right mix of core items and fashion. We are seeing nice progress this Back to School season, which we expect to continue into fall and holiday. Women's fashion knits and accessories, together with men's knits, are building momentum, and I believe we are driving the appropriate mix within the sportswear business. Another second quarter highlight, as Jim noted, was the expansion of accessories. We've seen a positive response on the women's side, where we are driving newness and innovation within our offerings. This is an exciting new business, which is ripe for an ongoing expansion, particularly during the holiday fast-turning season. Our high margin direct business was extremely strong, with growth in both traffic and conversion, leading to the double-digit sales increase.

Other highlights include the performance of our Manhattan stores, which are gaining momentum, and our international performance has been extremely robust, as Jim mentioned. Global demand for the AE brand has proven to be strong, providing support as we strategize future growth. From a merchandising position, Aerie continues to make very solid progress, not only in the foundations categories, but also in apparel. It's an exciting market opportunity with plenty of white space, and we are very pleased with the performance so far this fall. With the right team in place, developing great products, and importantly, advertising to drive brand awareness, we have the tools for successful growth. We have no control over the macro environment, and I recognize that it is very early in the fall season. With that said, I am encouraged by our progress and the impact our strategies are having on our business.

The AE brand is enduring and perfectly positioned. We are real with a broad and diverse customer base, which we embrace with passion. I want to take this opportunity to thank our teams for their dedication, passion, and hard work. These have not been the easiest of times, but I know with the talent and commitment we have across our organization, our progress will continue and lead to future growth and success. Let me turn the call over to Joan.

Speaker 2

Thank you, Roger, and good morning, everyone. Our second quarter can be summed up with the following: the top line demonstrated improvement, reflecting a stronger assortment and value offering. Although increased product costs pressured our margins, we delivered higher merchandise profit dollars. The gross margin declined due to the deleverage of rent. Expenses were well controlled, and our balance sheet remained strong. Now looking at the details, total second quarter sales of $676 million increased 4% from the second quarter last year, and comparable store sales were flat. Reflecting an improvement from recent periods, AE brand comps were flat, and Aerie declined 1%. Including the direct business, which had a 16% sales increase, consolidated comps increased 1%. AE direct sales were driven by new fall merchandise and upgrades to our website, which drove increased traffic and conversion.

Looking at second quarter metrics, a high single-digit increase in the average transaction value fully offsets the decline in the number of transactions. Now moving on to margin, gross margin decreased 250 basis points to 34.3%. While merchandise profit dollars increased slightly due to lower markdowns, increased product costs pressured the merchandise rate, which decreased 150 basis points compared to last year. BOW increased 100 basis points as a rate to sales due to rent related to new store openings, lease renewals, and flat comparable store sales. Turning to operating expense, even though comps were flat, SG&A leveraged 70 basis points. Controlling expense remains a top priority as we continue with our corporate profit improvement initiative. As previously discussed, we are reinvesting a portion of our savings into planned advertising designed to generate greater brand awareness, including Aerie.

One example of our ongoing opportunity for savings is the evaluation of long-term contracts upon expiration. For both the third quarter and the year, we continue to expect SG&A dollars to increase in the low single digits. Net income for the quarter was $20 million, compared to net income from continuing operations of $26 million last year. Turning to the balance sheet, as we indicated last quarter, we are investing in a year-round key item strategy to expand market share and underscore our strong value offering. The quarter-end inventory position supports that initiative. Ending inventory at cost per foot increased 30%, with half related to higher product costs. In addition to our investments in year-round key items, inventory is positioned to support our planned accessory expansion to 400 unique shop-in-shop formats during the second half of this year. Units per foot increased 15%, including the accessory expansion.

Looking ahead, third quarter average weekly inventory will continue to support the key item strategy and accessory expansion, resulting in inventory similar to the end of the second quarter. CapEx for the second quarter totaled $28 million, compared to $20 million last year. The increase reflects store remodeling activity in the second quarter. For the year, we continue to expect CapEx in the range of $90 to $100 million, with a little over half related to new and remodeled stores. We ended the second quarter with cash and investments of $515 million. Now looking forward, while we have tempered our outlook for the remainder of the year, particularly during non-peak shopping periods, we expect to see a sales improvement from the first half, driven by the initiatives we discussed today. The Back to School trend is positive, and promotional activity is consistent with our plan.

At this time, we expect third quarter EPS to be in a range of $0.22 to $0.27, which compares to adjusted EPS of $0.29 last year. Our guidance assumes margin pressure related to higher cotton costs and our planned promotional strategy. SG&A dollars are expected to increase in the low single digits. For the year, we expect EPS to be in the range of $0.85 to $0.95, compared to adjusted EPS of $1.02 last year. Now I'll turn the call back to Judy.

Speaker 5

Thanks, Joan, and now we'll move on to Q&A. Please be mindful of other participants today and limit your time in the queue. Okay, I'll turn it back to Rob.

Speaker 7

Thank you. We'll now be conducting a question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. One moment, please, while we poll for questions. Thank you. Our first question this morning is from the line of Adrienne Yih with Jefferies. Please state your question.

Speaker 3

Good morning, everyone.

Speaker 5

Morning.

Speaker 3

I guess for Roger, can you talk about the accessories? It really looks good in the stores and bringing traffic into the stores. I was just wondering how much of the square footage do you expect to dedicate to that as a % of the floor or a % of the floor set, however you want to define that? Can you talk about the margin implications, how much higher the margins are on that piece of the business and how we can expect that mix to flow in? Thank you.

Speaker 0

This expansion for us obviously is a new venture, and the IMUs are certainly higher. Where the business will end up, we'll see as we move through the holiday season. The space-wise, it varies by store based on store type, but its average is about 400 feet. At this point, we're really pleased with a lot of categories on the women's side of the business.

Speaker 3

Okay. Any comments on the extent of the difference in margin versus accessories versus apparel?

Speaker 0

Not at this point.

Speaker 3

Okay. Joan, just to follow up on the comp, can you give us a little bit of color on August month to date and/or July when you guys set your floor set in early July? Did you see a pretty immediate response in turning to the positive comp? Was there any slowness at the end of July similar to some other comment? If you can just tell us when you sort of saw that inflection point and is the guidance, are you sort of guiding implicitly for maybe a positive low and mid-single-digit comp for the fall season? Thank you.

Speaker 2

Sure, Adrienne. As I mentioned, our comp is positive, and we see that happening. As we started our Back to School promotional activity was when we really saw the positive trend kick in. We did get a nice response to the denim line as it landed in June, actually, and in the month of July. We did see a positive response to the key item selling in our core categories and knit tees and graphics and so forth. We did see a nice product response. The positive comp came as we went full bore into our Back to School promotional strategy. We'll really wait to see here to comment on what actual comps are as we get through the rest of the quarter. As you know, it's very early in the third quarter.

Speaker 7

Thank you. Our next question is from the line of Christine Chen of Needham & Company. Please state your question.

Speaker 6

Thank you. Just to sort of continue on the Back to School commentary, you know, denim clearly and the key items. What else is, you know, what else seems to be trending well? Excuse me. What is a little more challenging? With respect to Aerie, can you maybe update on the progress of that? Is that expected to break even this year still? Thank you.

Speaker 0

On Back to School categories, we're doing well pretty much across the board right now. The strength, you know, the beauty of the denim business for us on the women's side, in view of all of the competition and all of the pricing that's out there, our denim business on the women's side continues to be very strong. What's really nice is that the tops business now, the knit business for women's, which you know we've been redoing and redoing, we really have it on the right mark now. That's doing pretty, pretty terrific for us right now. Obviously, the pant business in both men's and women's, which is the non-denim part of the business. We made an investment for all of the warm weather stores in the short business because you know it's much more wear now than it's ever been. That's paying off for us as well.

Speaker 2

With respect to Aerie, Aerie is progressing very nicely. Jim mentioned in his remarks that we saw a margin improvement in the second quarter. Let me remind you that Aerie, as a brand, all channels, is a profitable brand for us. As we look forward into the back half of this year, we're excited about what happened with our Drew launch here in August and the marketing campaign that supported that. Into the fourth quarter, I would expect to see four-wall profitability for the Aerie stores to happen. We'll see four-wall profitability in the fourth quarter.

Speaker 7

Our next question is from Jeff Black of Citi. Please state your question.

Speaker 4

Yeah, thanks. Good morning, everybody.

Speaker 7

Morning, Jeff.

Speaker 4

Joan, on the inventory, I thought we were guiding for a low double-digit rise and units down, and we're coming in significantly higher on both of those accounts. Accessories, I get it, that accounts for some of it. When was the denim strategy contemplated? Is that what is driving the units? What kind of confidence do we have that the merchandise margins aren't going to be under some more pressure given where the inventories are? Thanks.

Speaker 2

Thanks, Jeff. The average inventory guidance that we gave, in fact, yes, was low double-digit, and that's where our average quarter came in for the second quarter. As we looked to, and as we said on the call, we were supporting the key item strategy, making strategic investments in a year-round key item strategy, which to your point includes denim as well as some of our basic top categories. The increase, as you talked about for the end of the quarter at 30%, half of that relates to product cost increases. The other half fully supports this investment in key strategy as well as the accessory expansion. Our view of inventory and the promotional strategy that Jim and both Roger mentioned are all factored into our view of guidance for the third quarter and into our outlook for the year.

Speaker 7

Thank you. Our next question is from Lorraine Hutchinson of Bank of America. Please state your question.

Speaker 6

Thank you. Good morning. Can you share with us the results of any price increase tests that you've begun for the early Back to School season?

Speaker 0

I'll take that question. We're very selective where we try to raise prices. Remember, we're the big brand. We have a strong customer base, and our customer base doesn't have a lot of money. We have to be very careful that we don't raise prices and lose our following. Value pricing for us is critically important, and the cost of cotton increase is a short-term phenomenon, which will go away, it looks like, for next year. We have been very careful in raising prices. We've only done it where we think we can benefit, and there we have.

Speaker 5

Oops. Rob, next question?

Speaker 7

Yes, our next question is from the line of Stacy Peck of Barclays. Please state your question.

Speaker 6

Hi. Just a couple follow-ups and then one question. One is, what is the AUC expected up in Q3 and Q4? What's inventories just on accessories or just in apparel, however you want to answer it? I guess fundamentally, it looks to me like comps are up because inventories are up so high. Where are you, Roger, on sort of improving tops? When do you think you will have the assortment that's going to sort of enable Eagle to gain back some positioning? Margin's down 10% from the good old days. I'm just kind of trying to figure out, is there some time period we should be looking at where you feel a lot better about tops or sort of where are we in the continuum? Thanks.

Speaker 0

On tops, on the men's side, they're doing extremely well. The knit business for us in men's is very strong. In women's, which started with the Back to School set, the knit business is very strong. As I said on the last call and the call before, we were redoing the teams. The teams are in place. I really feel very, very comfortable with where we are in terms of the knit business at this point. I was in the mall two days ago. I visited all of the stores. I think we're very focused. We're tight, and we have the right looks, and it's doing well for us, and our customer's responding.

Speaker 2

With respect to the average unit cost, Stacy, it's up mid-teen. The product cost is up mid-teen. The view of inventories, apparel versus accessory, the apparel unit increase is roughly 10%, and the accessory is about 5 points, bringing it to the full 15%.

Speaker 7

Thank you. Our next question is from Sam Pannella of Raymond James. Please state your question.

Speaker 6

Okay. Thanks, and good morning. I guess with respect to your direct business, you know, up nicely 16%, but being down last year, is there anything constraining stronger growth at that business?

Speaker 0

It's a terrific business for us. The site has been improved. It's about 12% of our business, which is a pretty good size business for a business that wasn't structured as a catalog business. It's growing at nice double-digit growth right now. We're really happy with it.

Speaker 5

Okay. Rob, next question?

Speaker 7

Sure. Our next question is from Janet Kloppenburg with JJK Research. Please state your question.

Speaker 6

Morning, everyone.

Speaker 2

Morning.

Speaker 6

A couple of questions, Joan. Units per foot are up 15% with accessories. I assume that's a higher investment in accessories. Are you saying units per foot are up the high single digits that you had guided for earlier? I wanted to know, Joan, at what comp can you leverage occupancy, please? Also, on inventory, should we expect year-end inventories to be up this much as well?

Speaker 2

Okay, Janet. With the units per foot, as I said, 10% relates to apparel. 5% relates to accessories. The guidance that we give doesn't include a quarter-end point of view due to in transit. The guidance I gave at a low double-digit increase includes an average weekly view of inventories, and we were in line with that throughout the quarter. The comp leverage point for occupancy is low to mid-single digit. The question on inventory, we would expect the fourth quarter to be similar to the third quarter with an ease of that inventory into the first half of the year.

Speaker 6

Okay. For Roger, can you talk about the level of success of your marketing program and your positioning, which I think has moved more bohemian, even a slash surf skate feel in the TV advertising in particular? If you could comment on the success of the women's fashion top business in the second quarter as well. Thank you.

Speaker 0

In the second quarter, the women's tops was not where we wanted it to be yet. As I indicated on the last call, we're working strongly on it for Back to School, and it's working. Fortunately, what we thought would happen is happening. As it relates to the marketing, we're really pleased. You know, the Aerie marketing, we're hearing great responses on, and it's really driving increased traffic into the stores, and the conversion is terrific. In the Eagle as well, you know, our advertising for the most part is really about denim. The denim business, especially on the women's side, is strong for us where it's a more fashionable business. Everyone has loved what we've done from the marketing perspective. In light of all of the competition out there at price points that are just amazing, to me, it's not having much of an impact that we can see.

Obviously, I guess we would be doing that much better if those price points were not out there.

Speaker 5

Okay, Rob, we'll take the next question.

Speaker 7

Our next question is from Brian Tunick with JPMorgan. Please state your question.

Speaker 1

Thanks. Good morning. I guess for Joan, maybe on the balance sheet, it looks like, you know, now that you've had that big inventory build, you know, when does returning cash to shareholders sort of move up from a priority perspective? If someone could update us on the CEO search, we'd be curious about that. Maybe just finally for Roger, just on the denim price points, it looks like a couple of times you've gone, you know, all denim below $30. Some of your main competitors are still a lot lower than that. Just curious if you're, you know, looking at that, thinking about, you know, reacting to that, or does the fashion, especially on the women's side, you know, give you the ability to keep your price points above them?

Speaker 0

I'll start on the denim. You know, listen, I don't want to sound too proud, but if you walk any street anywhere in the country, they're all wearing the backside of an American Eagle. They love our fit. They love our jeans. As long as we're priced at a reasonable price, they'll buy our jeans over anybody else's. I'm real proud of it. The organization has done one great job in accomplishing that. With that being said, we didn't own the inventory to replenish. Remember, when we talk about inventory, we're a bottoms-based business in American Eagle. We dominate in the bottoms business. The number of SKUs that's necessary in order to be able to replenish with the assortment that we carry in the bottoms business is quite sizable. For us, it turns pretty well, and it's pretty risk-free.

When you look at the base of the total inventory, it's very important to understand how much inventory we invest in the bottoms business and what we've done for this particular season. With that being said, our turn is still, the turnover is still pretty fast for a bottoms-based business.

Speaker 2

With respect to the cash, as you know, we have a strong track record of returning cash to shareholders. We do have $14.5 million or 14.5 million shares currently under authorization, and we'll continue to evaluate share repurchase along with dividends with our board of directors.

Speaker 5

Jim, would you like to address the CEO search question?

Speaker 4

Yeah, search has been activated, and we're moving forward. That's all we have to say right now.

Speaker 5

Okay, Rob, next question.

Speaker 7

Our next question is from Paul Lejuez with Nomura Group. Please state your question.

Speaker 6

Hey, thanks. Guys, when you first started opening Aerie stores, what kind of leases were you signing? Like what length? I'm just wondering what you've been doing as these leases come up for renewal, if some of them have, or if they haven't, I guess, what are your plans as they do? Do you expect to hang on to all those stores, or do you expect to get out of some of those leases? Also, just wondering, on the accessories business, what is that replacing on the floor? I'm just wondering why the investment in accessories accounts for so much of the inventory increase. Doesn't it replace something? Thanks.

Speaker 5

Jim, would you like to address the real estate?

Speaker 0

Oh, sure. All of the Aerie mall leases are 10 years in duration, and all of the leases have at a given time period what is termed a kickout clause. They usually run somewhere around a window of three to four years, with three being more than doable than not. As we look at some of these leases that are coming up, we make a determination whether we want to exercise the kickout or continue on for the duration of the lease. If the stores are not performing to a level of what we feel is an acceptable expectation, we would look to close those stores. To date, we have evaluated all of our stores, American Eagle included, under a major portfolio review.

We are in the process now of putting together a comprehensive plan as to what future markets will look like in North America, and that would include Aerie. Currently, the Aerie stores, we have to give them, as Roger was stating, a little bit of time because the latest collection and the efforts that we put behind this evolving lifestyle business are just starting to get traction. I wouldn't want to make a foolhardy decision to close a store that eventually we want to have in that particular shopping environment. There are indications that certain stores are probably not deemed to be appropriate for certain markets, and that they should be targeted to close. You would hear more about that in the future. On the accessory expansion, as a company, we have over a thousand-store fleet. On a selling foot basis, we do over $500 a foot.

One would say, where'd you find the space? We did our due diligence, and it's amazing how we came up with 400 stores that absolutely had the room for us to create an accessory shop either in the back area where it was originally supposed to have been or around the cash and route. Quite frankly, we didn't need to do anything else other than carve it out.

Speaker 5

Okay, Rob, next question.

Speaker 7

Our next question is from the line of Michelle Tan from Goldman Sachs. Please state your question.

Speaker 6

Great, thanks. You know, Roger, I agree with you. I think that the product's starting to look more on brand. I'm surprised that with better sales against the easy comparisons you had from last year, that your markdown rate didn't improve more. I can't help but thinking it's because of the amount of investment you keep putting behind inventory. I guess, can you give us any color on where that markdown rate sits now versus where it used to be several years ago and what levers you're thinking about to unlock that opportunity? You know, how you think about the balance of inventory, what else can happen going forward?

Speaker 0

I really like where our inventory is, and I know you guys figure out turnover and look at, if you look at a bottoms-based business, you'll see that this inventory level is about right now. We'll be able to satisfy our customers. We can replenish where we need to. I'm pretty damn comfortable with where we are in terms of the inventory. In terms of the markdowns, it's a bit higher than I would like it to be. It's still a relatively low number in this business. It's because of the competitive environment out there. If you factored the difference in the cost of goods based on cotton, we would be making more money. That hopefully will come back to us as we move through 2012.

Speaker 5

Okay, thanks, Rob.

Speaker 7

Our next question is from Betty Chen of Wedbush. Please state your question.

Speaker 3

Thank you. Good morning, everyone.

Speaker 6

Good morning.

Speaker 3

Morning. I was wondering if you can speak a little bit to the online business. It grew nicely, up 16%. I think you alluded to higher traffic and transaction conversions as well. What, if any, differences are you seeing in that online customer versus the one from the stores? Any learnings that you can carry over to the brick-and-mortar part? My second question is around 77 Kids and Aerie. Where do you still see the longer-term store potential, the number of stores for each of the concepts? When should we expect, although quite early, when should we expect 77 Kids to also potentially reach either break-even or profitability? Thank you.

Speaker 0

Yeah, you know, the synergy on e-commerce and stores is terrific. The teams that we have in the e-commerce business now are teams that were merchants running the AE brand business. Now with Fredrick Grover heading up merchandising and e-commerce and Michael Leedy back in marketing, the whole combination is very powerful. This e-commerce business is really, really, for us, growing. It's really showing the strength of the brand. We're now using the e-commerce strategy to even drive more traffic into our stores. The whole combination, I'm really happy with right now.

Speaker 5

Jim, would you like to address the question on store potential for kids?

Speaker 0

Yeah, sure.

Speaker 5

Aierie?

Speaker 0

Ironically, and not necessarily will they all be in the same locations, but the plan is for approximately 350 to 400 stores in North America for both Aerie and 77 Kids. The numbers just happen to work out that way. It's rather obvious, and I think I've stated this a few times in the past. We do not expect either the Aerie or 77 Kids to have the same number of stores that we do have at American Eagle. I think that both the brands are of a nature where we want to be strategically located, but we really don't want to be on every street corner in America. It provides a little bit of more exclusivity to the brand. Joan and I have run some quick numbers on the profitability for kids.

Right now, on its current cadence, I would expect we both would expect the brand to be profitable in 2013, with major improvement in 2012.

Speaker 5

Good. Okay, Rob, next question, please.

Speaker 7

Our next question is from the line of Dorothy Leichner with Harrison Company. Please state your question.

Speaker 6

Thanks, and good morning, everyone. Roger, I wondered if you could just comment a little bit more on denim. I know you love to talk about it. Where the comp actually is tracking since you've had a good track record in the category, and it's certainly been pretty promotional this season, but you seem to be very positive about it. Where the comp is there. Secondly, on Aerie, where the apparel comps are tracking versus the core foundation business. Lastly, for Jim, just how the remodeled stores are continuing to perform for you. Thanks.

Speaker 0

Dorothy, hi. I'm not going to give specific numbers out three weeks into the Back to School quadrant, but women's denim is doing very well for us. And Aerie is doing terrific.

Speaker 5

Can you talk about apparel?

Speaker 6

Aerie is doing well in both the apparel side of the business, as well as the core foundation side of the business, Dorothy.

Speaker 5

Jim, did you want to address the remodels?

Speaker 0

Oh, sure. Dorothy, on the remodels, I think all of you who have followed the company for quite a while know that in the next, actually, this year of 2011 and 2012 and 2013 will be the largest number of stores that we had the leases coming due because of the growth cycle we had 10 years ago, 11 and 12 years ago, respectively. We have looked at remodels a little differently currently than we have in the past. In the past, when we had maybe what we would call 25 or 30 remodels, we would look at redoing the store. Now that we have remodels, that number is well into 130 to 150 locations.

We've now broken it down into a number of different financial variables as to, and it's by market and by store volume, whereby we will do anything as short of just sort of a freshening up, and that's a paint and lighting to a full-scale remodel, which would be the entire store to be redone. The entire store redos are very, very limited numbers, so we're keeping our CapEx costs down. The short answer is that I'm very pleased with the results of our remodel, both on the less expensive version as well as the more expensive version. Our remodeled stores continue to outperform our stores that have not been remodeled on both a gross sales as well as a modest single-digit comp store sales.

Speaker 5

Okay, great. All right, next question, Rob.

Speaker 7

The next question is from the line of Dana Telsey of Telsey Advisory Group.

Speaker 3

Good morning, everyone. Can you talk a little bit about the tops business, both on the women's side and the men's side? You mentioned the improvement in knits. What are you seeing there, price promotions versus price points, and also on the graphic tee side of the business? Do you expect knits versus denim? How are you thinking about the holiday season? Thank you.

Speaker 0

Obviously, Dana, for holiday, we're going to be pretty, pretty aggressive on the knit side of the business, which is a holiday giving business. It is quite amazing that our denim business during the holiday period is almost as strong as it is during the Back to School period. We will own the inventory this year to be able to replenish, and the assortments that we have and the fashion that we're playing with, you like what we have. We feel pretty good about that.

Speaker 5

Thank you, Jason.

Speaker 0

Okay.

Speaker 5

Okay, next question.

Speaker 7

The next question is from the line of Jennifer Foyle of Lazard Capital Markets. Please state your question.

Speaker 6

Hi. Thanks for taking my question. Actually, two clarifications, please. On the apparel units, I think you said that inventory increased 10% and accessory units increased 5%. Could you break that down in dollars? I assume that there's a bigger increase in apparel given the cotton prices. Also, wondering if I could get a little more color on comps, the UPT, AUR, traffic, and conversion. Thanks.

Speaker 2

With respect to the inventory, yes, apparel units were up 10% at quarter end, and the accessory is 5 points of the 15. With respect to cost, Jennifer, 50% of the increase in our ending inventory relates to product cost increase. About 5 points of that of the balance relates to accessories, and the other 5 points relates to key item investment. With respect to the quarter and the sales metrics, we had a very nice increase in our AUR in the quarter. Traffic, however, was down, but our conversion remained strong, speaking to the points that Roger was making on the strength of the assortment during what we would consider a relatively tough traffic period.

Speaker 5

Okay. Next question, Rob.

Speaker 7

Our next question is from the line of Jeff Van Sinderen of B. Riley. Please state your question.

Speaker 6

Hi. I guess this is really a clarification question. In terms of the overall promotional cadence versus last year, are you currently more or less promotional for Back to School versus last year? What is the plan for level of promotional cadence versus last year for the remainder of this quarter?

Speaker 0

I would say we're a bit more promotional than we were last year in view of the climate out there. The stores and the malls are much more competitive than where they were last year. We're right on our cadence of what our strategy was. I feel pretty good that we don't need to go further than our strategy in order of meeting the competition and gaining market share.

Speaker 5

Okay, next question.

Speaker 7

Our next question is from the line of Kimberly Greenberger of Morgan Stanley. Please state your question.

Speaker 6

Great. Thank you. Good morning. Joan, I thought I heard you say average unit retail was up in the second quarter. I'm wondering if you can help us understand the magnitude of that. Just looking back in the model, it looks like the last time we saw a 30% spread between total sales growth and total inventory growth was at the end of the second quarter of 2005, following which the gross margin rolled over. I'm just wondering how carrying a heavier level of inventory doesn't result in merchandising margin pressure going forward. If you could just help us understand that, that would be great. Thanks.

Speaker 2

Sure. The color on the AURs was up high single digits, and it nicely offset, which drove the average transaction value up, Kimberly, which then nicely offset the decline in transactions related to traffic. With respect to the inventories, the key point to think about is this replenishment thought and the idea that this is year-round inventory that we're holding in stock to replenish and maintain a size integrity to ensure we protect our franchise and the cornerstone of our brand in denim. That's number one. This idea on this key item strategy on basics or core items in tees and in graphics, these are styles that can live longer. They can carry over into the spring season, and we can continue to turn those.

With that in mind, we feel comfortable with the guidance projection or guidance that we have for the third quarter because we have the promotional plans baked in or laid in that Roger mentioned. We can continue to offset for our customers and with the hope that we will effectively drive the top line.

Speaker 0

Keep in mind that half of that cost of goods is in the cost of the cotton.

Speaker 5

Okay, Rob, we have time for one more question.

Speaker 7

Okay, the next question will be coming from the line of Jennifer Black of Jennifer Black and Associates.

Speaker 6

Good morning. I have a couple of questions. I wondered, Roger, if you see a more preppy cycle coming, and I'm just talking about retail across the board. That's my first question.

Speaker 0

Yes, obviously, we see preppy, but we see preppy, obviously, with other variations. It's not the old preppy, but it's the new preppy.

Speaker 6

Okay, so you won't be moving away at all from the bohemian look. Is that correct?

Speaker 0

I didn't say that.

Speaker 6

Okay. I wondered if you could talk about the AE campus stores and the outlet centers. Obviously, you get lower rents, but I was curious about the productivity you're seeing versus your mall stores.

Speaker 0

Yeah, Jim O'Donnell will take that one. He likes that one.

Speaker 6

Thank you.

Speaker 4

Jennifer, thanks for using the term off-campus.

Speaker 6

Sure.

Speaker 4

Actually, you know, this whole outlet center phenomena that's really emerging throughout North America, primarily here in the U.S., used to have a negative connotation, sort of, you know, low prices and not exactly a great shopping experience. That whole attitude and perception is now gone, and they're quite the place to shop because of the mix of retailers that are there. Anyway, that is the backdrop. We are very pleased with our off-campus business. We have developed a model that we think can really survive the test of time. What that means is the financial goals and objectives that we've set down, although modestly aggressive, we've been meeting and beating those in most every instance.

Yes, the overall potential profitability because of lower rents, and it's also a lower overhead because you don't have a common area maintenance and other expenses that are fixed to a mall location, give you the channel to be incredibly profitable. We're on that path. We're very, very pleased. I have an excellent team in place. The stores are run like an American Eagle store, although the product mix does deviate somewhat for our off-campus stores. Clearly, they run with the same standards of an American Eagle mall store. The driving force is a combination of the inventory that we put in the stores. Especially in this type of an economy, I think it's rather obvious to all of us. They have the perception and the traffic patterns are incredible in these shopping centers across North America, primarily here in the U.S.

Speaker 6

Do you plan on further, I mean, are you going to put your foot on the accelerator with these stores? I guess you didn't exactly answer my question. As far as the productivity versus the mall stores, would it be fair to guess 20 to 30% higher?

Speaker 4

The quick answer is yes on that. As far as the strategy for growth, most of our new stores, I would say 90% of our new stores are planned to be off-campus stores. Right now, we have, I believe, around 52 or 53. I think we have the capability over the next few years to have somewhere of 100 stores. I just want to put a caveat in there. You know, we've done this portfolio review on our entire fleet, and I will not be putting in off-campus stores at the expense of a mall store. It is a very precise exercise that we go through to ensure that if we layer in an off-campus store, it will not have a negative effect on a mall store. In some cases, the off-campus location would be viable, and then we would look at potentially a mall store.

If it's not as proficient, then we would, and at the proper time, we probably would terminate and only have a presence of one mega store in a particular market. They have been, on average, about 20% to 30% more profitable than what would be a mall store.