Abercrombie & Fitch - Q2 2012
August 17, 2011
Transcript
Operator (participant)
We ask that you limit yourself to one question during the question-and-answer session. At this time, I would like to turn the conference over to Mr. Eric Cerny. Mr. Cerny, please go ahead.
Eric Cerny (IR Manager)
Thank you. Good morning and welcome to our second quarter earnings call. Earlier today, we released our second quarter sales and earnings, income statement, balance sheet, store opening and closing summary, and an updated financial history. Please feel free to reference these materials available on our website. Also available on our website is an investor presentation, which we will be referring to in our comments during this call. This call is being recorded, and the replay may be accessed through the internet at abercrombie.com under the investors section. Before we begin, I remind you that any forward-looking statements we may make today are subject to the safe harbor statement found in our SEC filings. Today's earnings call will be limited to one hour. Joining me today on the call are Mike Jeffries and Jonathan Ramsden.
We'll begin the call with a few brief remarks from Mike, followed by a review of the financial performance for the quarter from Jonathan. After our prepared comments, we'll be available to take your questions for as long as time permits. Now to Mike.
Mike Jeffries (CEO)
Good morning, everyone. Thank you for joining us today. We are pleased that our results for the quarter continued to reflect strong momentum both in the U.S. and Europe. For a third consecutive quarter, our sales were up more than 20%. This included a strong performance from new stores, particularly the Paris flagship, but also the 19 new Hollister stores we have opened in Europe in the last 12 months. In addition, our U.S. chain store business performed well for the quarter, particularly Hollister, fueled by what we believe is a compelling assortment and supported by effective pricing and promotional strategies. We had long anticipated that the second quarter would be challenging from an operating income standpoint, considering the effects of investments we are making for future growth.
In that context, we are pleased that our top-line performance enabled us to significantly beat our internal goal for the quarter and achieve a 71% year-over-year increase in operating income. Our second quarter results marked the midpoint of the three-year roadmap we laid out at the beginning of last year. Our focus remains very much on execution against our strategy and the key roadmap objectives while always maintaining a long-term view. We believe maintaining that long-term approach is even more critical today given the uncertainty in the macroeconomic environment. I will come back to that in a moment. First, I want to take a few minutes to review our performance to date against our roadmap goals. Starting with U.S.
store productivity, we have clearly delivered on the objectives we laid out in February of last year, and we believe we are on course to sustain meaningful improvements and drive back toward peak productivity levels. These improvements have been driven by several factors. First and foremost, by having the right merchandise and maintaining a compelling and differentiated store experience. In addition, our pricing and promotional strategies have played a role in the productivity improvements we have seen, and we have improved our execution of these strategies. However, no one should conclude that even in the U.S. chain business, this is a purely price-driven business. Even in an environment where price is increasingly important, you have to be a desirable brand that clearly stands for something in the eye of the consumer.
With regard to marketing and customer engagement, we have made progress, but we still see plenty of opportunity ahead of us. Turning to international, we expect to hit our goal of close to 40 international Hollister openings and five Abercrombie & Fitch flagship location openings this year. Overall, the international stores we have already opened continue to perform very strongly. Tomorrow marks the opening of our first Hollister store in Asia at the Festival Walk Mall in Hong Kong. This is a significant milestone for us, and we look forward to our first openings in mainland China later in the year. In Europe, the performance of our Hollister business continues to be very strong, and our new store openings for the quarter are significantly exceeding plan in aggregate.
As I mentioned a moment ago, we are also very pleased with our Paris flagship opening, and while it is still early on, we continue to expect its volume to be in the same range as the London and Milan flagships on a go-forward basis. Turning to Japan, our business there remains challenged, with Ginza comping negatively through the quarter. We remain cautious on Japan while we work to identify and address the underlying issues. Our Canadian business is also not where we would like it to be, although it continues to operate at a healthy profit level, and we believe the sales trend in Canada is more readily addressable. Our direct-to-consumer segment again posted strong growth of 28% for the quarter as we work toward our billion-dollar goal. This business remains a major strategic priority and source of investment.
As for Gilly Hicks, we continue to work on our strategic roadmap objectives and remain very excited about the long-term prospects for the brand. Last, we continue to focus very closely on expenses and challenge ourselves in each area of our business to find additional efficiencies in our model. This is all the more important in an uncertain macroeconomic environment. Overall, we are pleased with our performance against our strategic roadmap goals. As we look to the back half of the year and into 2012, it is clear that we are entering a period of greater uncertainty. As we have discussed in the past, costing issues will certainly impact us more significantly in the back half of the year, and the consumer response to price increases remains unclear.
In addition, the global macroeconomic picture and possible exchange rate volatility add to this uncertainty, especially given the increasing share of our business represented by Europe. However, our strong top-line momentum and overall performance for the past several quarters give us confidence that we are well positioned to navigate through this environment. While external risks have increased, we remain comfortable with our objective for next year. With that, I'll turn the call over to Jonathan, but we'll be happy to take your questions later in the call.
Jonathan Ramsden (CFO)
Thanks, Mike, and good morning, everyone. As Mike said, the story of the quarter was essentially that a strong top-line performance mitigated the deleveraging issues we had faced coming into the quarter and enabled us to deliver meaningful growth in operating income and EPS. Sales for the quarter increased 23% to $917 million. Total domestic sales, including DTC, were up 12%. Total international sales were up 74%. Within international, Hollister. Europe was particularly strong, both for comp and non-comp stores. Overall, DTC sales, including shipping and handling, were up 28%. As reflected on page six of our presentation, foreign currency changes accounted for approximately 160 basis points of the sales increase based on converting prior sales at current year rates. The impact of foreign currency changes on our results is likely to increase going forward as international operations account for a greater part of the mix.
Gross margin for the quarter was 63.6%, down 150 basis points from last year, putting our gross margin for the first half of the year up 40 basis points. Gross margin dollars for the second quarter increased 20% versus last year. The decrease in the gross profit rate was driven primarily by an increase in average unit cost, partially offset by a higher AUR and an international mix benefit. AUR was up mid-single digit for the quarter, with increases in both U.S. and international AURs. Across all brands, men's and women's comps were similar. Men's stronger performing categories were knit tops and fleece, while graphic tees were weaker. Women's stronger performing categories were woven shirts and sweaters, while graphic tees were weaker.
Turning to operating expenses and page seven of the investor presentation, stores and distribution expense for the quarter included store occupancy costs of $173.6 million in line with our guidance. All other stores and distribution costs represented 27.5% of sales. Due to the strong sales performance, we saw less deleverage on this line than we had anticipated. As a reminder, these expenses also include $4 million of additional depreciation related to our DC consolidation. MG&A for the quarter increased 16% in line with our mid-season guidance, driven by increases in compensation, including incentive and equity compensation, marketing, and other expenses, net of favorable prior year legal settlements. MG&A for the quarter included equity and incentive comp of $18.4 million versus $11.7 million last year. For the quarter, and excluding the effect of prior year store closure costs, we achieved approximately 300 basis points of expense leverage.
Overall, operating income was up 71% for the quarter. The tax rate for the quarter was 30.7% and benefited from the strong performance of international operations with a lower effective tax rate. On a full-year basis, we now expect that the tax rate will be somewhat below 35%, although this remains sensitive to mix shifts between domestic and international taxable income, including the effect of currency movements. Diluted EPS for the quarter was $0.35, $0.13 above last year, which included the $0.02 loss last year from store closure charges. Year-to-date EPS diluted is up $0.54 versus last year. Turning to the balance sheet, we ended the quarter with total inventory at cost up 7.5% versus a year ago, or up 3.5% excluding in transit.
Coming into the back half of the year, we believe we are appropriately positioned with fall and basic inventory, although our spring carryover inventory is somewhat lighter than we would have liked, reflecting the strong first half performance. During the quarter, we repurchased approximately 950,000 shares at an aggregate cost of $64.4 million, bringing our total repurchases over the past 12 months to approximately 3 million shares at an average cost of approximately $56 per share. We ended the quarter with approximately $540 million in cash and cash equivalents, compared to $596 million in cash and equivalents at the comparable point last year. This number reflects buybacks and dividends of approximately $225 million in the past 12 months and a paydown of $53 million in revolver debt, in addition to which we have eliminated substantially all outstanding letters of credit.
Turning to the third quarter and back half of the year, we continue to expect gross margin erosion. However, our visibility on the magnitude of this erosion is less clear than in the first half of the year due to the uncertainties Mike spoke to earlier. Some more specific guidance on third quarter expenses is included on page 11 of our investor presentation. This expense guidance excludes the impact of any potential impairment charges resulting from our annual review of long-lived assets. Store occupancy costs for the third quarter are expected to be in the low to mid-$180 million. All other stores and distribution costs are expected to modestly delever compared to last year's rate of 24.8%, including the effect of pre-opening costs, DTC investments, and additional depreciation due to the DC consolidation.
MG&A for the third quarter is expected to increase by a low double-digit %, with the primary components of the increase being equity compensation and marketing costs. Going forward, as we have spoken to in the past, equity compensation charges may escalate significantly. This is a function both of potential increases in the stock price, but also of a shorter amortization period for future awards. As a result of the approval of our amended long-term incentive plan, we no longer anticipate that you will need to adopt liability accounting for equity-based awards. Our plans for store openings for the year remain in line with prior guidance. We now expect to close approximately 60-65 U.S. stores during the fiscal year, significantly all through natural lease expirations.
Based on current new store plans and other planned expenditures, the company continues to expect total capital expenditures for 2011 to be approximately $350 million. This concludes our prepared comments section of the call. We are now available to take your questions. Thank you.
Operator (participant)
Question-and-answer session is conducted electronically. If you would like to ask a question at this time, please press star one on your telephone keypad. Again, that's star one if you have a question at this time. Take our first question from Lorraine Hutchinson with Bank of America.
Lorraine Hutchinson (Retail Analyst)
Thank you. Good morning.
Mike Jeffries (CEO)
Good morning, Lorraine.
Lorraine Hutchinson (Retail Analyst)
I just wanted to follow up on the gross margin commentary. I know that the visibility is pretty unclear at this point, but if you could just provide us with any commentary on how, you know, initial price increases have gone, what the consumer acceptance has been, what types of cost increases you're seeing, just any guidelines you could give us to help us try to model this line item.
Jonathan Ramsden (CFO)
Lorraine, I don't think there's a whole lot of additional color we can really add. I mean, I think we've long said that we were talking about double-digit cost increases in the back half of the year and actually starting late in the second quarter. As Mike said earlier, the reaction to price increases, which for us have not yet fully gone into effect, remains unclear, and it's certainly too early for us to add a lot of color to that. I'm not sure beyond what we've already said that there's really a whole lot of additional color we can provide at this point. Clearly, as we go through this quarter in particular, we'll have a greater sense of that.
Operator (participant)
Thank you. We'll go to our next question. Christine Chen with Needham & Company.
Christine Chen (Analyst)
Thank you. Congratulations on a great quarter.
Mike Jeffries (CEO)
Thanks, Christine. Morning.
Christine Chen (Analyst)
Morning. Wanted to ask about the price increases. I mean, as I walk the stores, I do feel like there has been at least a mix shift towards higher price point items, particularly on the fashion side and maybe even on the denim side. How are you thinking about those price increases? Is it across the board? Is it skewing the mix? Is it more in fashion versus basic? Thanks.
Jonathan Ramsden (CFO)
Yeah. Hey, Christine. I think we've always said that it was not going to be uniform, that it would be based on what we thought was appropriate category by category and item by item. I'm not sure there's a whole lot of color we can really add on that.
Mike Jeffries (CEO)
I think, let me just pipe in. There clearly is a mix influence happening in our inventories, as our inventories are shifting to a greater percentage fashion, which is what you observe in the stores.
Christine Chen (Analyst)
For the fashion penetration, can you maybe shed some light on how much that's gone up?
Jonathan Ramsden (CFO)
Oh.
Christine Chen (Analyst)
I had to ask.
Mike Jeffries (CEO)
Good question. I think you see it in the stores. Thanks, Christine.
Operator (participant)
Thank you. We'll go to our next question, Randal Konik with Jefferies.
Randal Konik (Analyst)
Hey, can you hear me?
Mike Jeffries (CEO)
Yeah, we're hearing you, Randy.
Randal Konik (Analyst)
Hey, guys. What's up? Just a quick question. I guess near term and long term, I guess Mike first. The comment in the press release about the strong top-line momentum, is it, how should we be thinking that, is that momentum continuing into the back-to-school period thus far? How should we be thinking about, how are you thinking about the back-to-school season from your perspective? I guess, Jonathan, can you give us any type of updated commentary from the, after the analyst meeting on that $475 million number for next year? How are you feeling about that? Thanks.
Mike Jeffries (CEO)
Okay. Let me comment. First question. We've never given guidance on sales during a quarter, and we're not going to now. I cannot and will not comment on August. What I can tell you, and I think this is the important point, Randy, is that our business has always been built and managed with a long-term orientation. That applies to protecting the quality of our merchandise and store experience. It applies to our long-term relationships with our vendors, many of whom have been with us for many years. It applies to our people for whom we want to create long-term rewarding careers. It also applies to our stockholders, where we are fortunate to have some long-term supportive stockholders who understand our strategy and what we are trying to accomplish. I'd like this to be my biggest message this morning.
Jonathan Ramsden (CFO)
Randy, just coming to the second part. We remain comfortable with the $475 million for next year. The things that are under our control, we feel good about. We've been ahead of our objectives year to date, so that's a positive factor. I think weighing in the opposite direction is clearly the macroeconomic uncertainty. Net of those two things, I think our outlook is essentially neutral to where it was when we published that number at the Investor Day back in April.
Operator (participant)
Thank you. As a reminder, we do ask that you limit yourself to one question during the question-and-answer session. We'll go next to Brian Tunick with JPMorgan.
Brian Tunick (Analyst)
Thanks. Good morning, guys.
Jonathan Ramsden (CFO)
Hey, Brian.
Brian Tunick (Analyst)
I guess the question is on the gross margin side again. Just trying to understand sort of your commentary on the back half. Is the concern about, you know, more on the average unit cost side and what do your lead times look like? You know, when do we start to feel the benefit of what's happened to cotton? Or is it more on the competitive landscape, particularly seeing, you know, where Hollister denim might be going out the door now versus some of your competitors?
Jonathan Ramsden (CFO)
Let me go through some of the components of gross margin, which I think illustrate why we're saying there's less visibility in the back half than we had in the front half. First of all, you've got the average unit cost effect, which we obviously know at this point for the back half of the year. I'll come back to forward expectations on that in a second. We've got price increases in the mix, which we've clearly said it's too early for us to say what the reaction to that is going to be. We've got the possibility of a slowing economy, a potential double-dip recession, which obviously could impact our business. I think it's too early to say on that yet, but clearly that has increased in terms of the likelihood over the last couple of months.
I think another big factor you have to also throw into the mix is we've got a very significant number of new stores opening internationally in the back half of the year, far more so than in the first half of the year. The volumes we've attached to those stores could have a significant impact on where we end the year from a gross margin standpoint. There are a lot of different variables in the mix. Currency on top of that is another one, given our increasing proportion of our business in the eurozone in particular. Just given all those variables, unlike our feeling six months ago when we were pretty comfortable saying approximately flat gross margin for the spring season, we're not comfortable being that specific in the back half of the year, but we do certainly expect there to be erosion in the gross margin rate.
Going forward in terms of costing, we'll have a relatively tough comparison in the first quarter of 2012 because, as you probably recall, we got very good costing in the first quarter of 2011. We should start to see from year-over-year favorability with regard to cotton halfway through the second quarter of next year, although I think it's also clear that the non-cotton components of costs are continuing to inflate, particularly labor costs. The cotton, based on where it stands today, would start to turn more favorable for us on a year-over-year basis in the middle of the second quarter of next year.
Brian Tunick (Analyst)
All right. Terrific. Thanks, guys.
Jonathan Ramsden (CFO)
Thank you.
Mike Jeffries (CEO)
Thank you.
Operator (participant)
We will take our next question from Dorothy Lackner with Caris & Company.
Dorothy Lackner (Analyst)
Thanks. Good morning, everyone, and congratulations from me as well. Just wondered if you could provide a little bit more color on the Paris opening. Obviously, that was a pretty big one for you. How that was perhaps different from the London opening or the Milan opening, and what kinds of things you're learning about that. Just a corollary to that, what you're seeing in terms of foreign tourist business here in the U.S.
Mike Jeffries (CEO)
Okay. Let me talk a little about the Paris opening. It was an opening that was very much like the London opening and the Milan opening. We had lines and excited customers. I think what we're learning about the flagship is that we have a chain in the flagships. We're running a chain of flagships. We open each of those stores exactly the same way, and it's interesting that we're getting the same response. It leads to the point that we operate our stores the same wherever they are in the world. From a customer's perspective, we are one experience, and that's being borne out in the flagships. Exciting opening, exciting business continuing, and we look forward to more in the future. Foreign tourist business in the U.S., I guess I can comment on last quarter, continues to be good.
Thank you, Dorothy.
Operator (participant)
Thank you. Our next question comes from Janet Kloppenburg with JJK Research.
Janet Kloppenburg (Analyst)
Good morning, everyone. Congratulations. Nice [audio distortion].
[crosstalk]
Mike, I was wondering if you could talk a little bit about your level of happiness with the new denim introduction. I thought it was really well done, and I love a lot of the new fits and washes. I wondered if you could talk a little bit about how important that is to your business going forward. I was also wondering if you could talk a little bit about how you view the discounting environment in the U.S. and if you think it's something that we're just going to have to get used to or if you see some evolution unfolding where you may be able to be less promotional. Jonathan, just for you and your outlook for fiscal 2012, my question is, when you think about the $475 million, have you thought at all about the FX benefit you've been incurring and what might happen?
Is there any assumption there for a softening of the euro? I think is my most direct question. Thanks so much.
Mike Jeffries (CEO)
Okay. First, Janet, denim, I think that the new denim fits and washes were very important to us. I think this organization did a really good job in re-engineering our denim. I think it's interesting that we're getting real credit for that. Promotional outlook, I don't have a crystal ball. I really don't. We will see what happens in the U.S. Clearly, it's a U.S. issue for us and not an issue in the rest of the world. We are very optimistic about our offerings, and we would hope that over time, the U.S. could become less promotional. That's our intention. Let's see what happens.
Jonathan Ramsden (CFO)
Janet, on the second part of the question, we certainly do look at the sensitivities of all the critical components of getting to that $475 million, and FX is definitely one of the more sensitive components of that. Relative to when we put that objective out there, the euro has strengthened, or certainly it had with regard to our second quarter result. We do not specifically factor in a cushion for that, but we look at the potential sensitivity of exchange rates relative to the other sensitivities in the model around domestic same-store sales, around international store openings. We weigh reasonable outcomes or reasonably likely outcomes on each of those components. Based on all that, we continue to think at this point the $475 million is realistic. I think it is.
Having said that, clearly when we put that objective out there, we were not modeling in a double-dip recession in the U.S. or a major decline in the euro. Absent either of those things happening, we remain comfortable with that objective.
Mike Jeffries (CEO)
Janet, one more point about the denim. I think it's clear, and everyone should understand that our back-to-school strategy was to get our new fits on as many new customers or old customers as possible.
Operator (participant)
Thank you. Our next question comes from Stacy Pak with Barclays Capital.
Speaker 29
Hello?
Mike Jeffries (CEO)
It doesn't sound like Stacy.
Speaker 29
Hi, this is Ed, actually, standing in for Stacy.
Mike Jeffries (CEO)
Okay.
Randal Konik (Analyst)
I just had a quick two questions. One is, I know you didn't, you want to comment on August month to date, but we just wanted to know how are the trends looking? The second question is, could you comment on whether you still intend to increase prices in September and what comp for the business looks like when you remove the promotional stance in the U.S.? Thanks.
Jonathan Ramsden (CFO)
Yeah. Hey, Ed, I think we already said that we're not going to, you know, we've never commented on intra-quarter, intra-month sales overall.
Mike Jeffries (CEO)
Can we just pass a message to Stacy? Nice try.
Jonathan Ramsden (CFO)
I think with regard to prices, I think we've already covered that. The question on what would comps look like without promo in the U.S., I don't think we would even know how to go about quantifying what that would be.
Operator (participant)
Thank you. Our next question comes from Jeff Klinefelter with Piper Jaffray.
Jeff Kleinefelter (Analyst)
Hi, Jeff.
How are you doing?
Mike Jeffries (CEO)
Good. How are you?
Jeff Kleinefelter (Analyst)
Good. Just a couple of quick questions. In terms of the Hollister openings for the back half, you've got many of those scheduled now to hit in the next two quarters. Jonathan, could you give a little bit more color on how you expect those to hit between Q3 and Q4? Are they continuing to track at a certain multiple of the average, you know, U.S. volume or U.S. productivity? I think just to clarify, hadn't you guys been giving a sort of a general comp outlook for the total enterprise on kind of either quarterly or a second-half basis? I'm not sure if I missed that regarding your Q3 expense guidance.
Jonathan Ramsden (CFO)
Thanks. Hey, Jeff. I guess with regard to the Hollister openings in the back half of the year, they're roughly even between the third and fourth quarter in broad terms. In terms of the productivity of the stores we have open, as Mike said earlier, the stores we opened during the quarter in aggregate exceeded plan. Hollister Europe business remains very strong, both comp and non-comp. It's really pretty consistently good across the board for Hollister in Europe. We are hopeful that those stores we are going to open in the back half of the year will sustain that trend, and we don't see any reason why that wouldn't be the case. The second part of the question was, what was it?
Speaker 30
[audio distortion]
Jonathan Ramsden (CFO)
Oh, yeah. I think with regard to the comp outlook, you know, we've spoken going back to the Investor Day in April, Jeff, about what we're targeting. That would be, you know, clearly what we've accomplished year to date is consistent or better than that. To be on track with our objectives, we're looking to sustain meaningful improvements in comp store sales going forward. I think at this point, for all the reasons we've alluded to, we're not going to be more specific than that. Relative to our objective, both for this quarter and beyond, we're certainly targeting sustaining those improvements that we've seen.
Operator (participant)
Thank you. Our next question comes from Michelle Lim with Goldman Sachs.
Michelle Lim (Analyst)
Great. Thanks.
Jonathan Ramsden (CFO)
Morning.
Michelle Lim (Analyst)
Hi, guys. We know you guys had a great July and start to back to school. I'm just curious to clarify, with all the commentary on uncertainty that's come up in the macro environment over the last three months, are you guys really talking about being concerned about things that can have a future impact on your business that you're seeing externally? Is there some sign of increased uncertainty as you look at whether it's day-to-day volatility in the business or whatever that you see in your trends today?
Jonathan Ramsden (CFO)
Is that a question about all the sales?
Michelle Lim (Analyst)
Volatility, not absolute number.
Jonathan Ramsden (CFO)
I think, you know, we're not doing anything different than anybody else, which is whether there's a significant, you know, a greater degree of uncertainty out there. You naturally kind of think about what the impact that could have, and you want to be prepared if that becomes more significant. I don't think we're saying anything more than that at this point, Michelle.
Operator (participant)
Thank you. Our next question comes from Kimberly Greenberger with Morgan Stanley.
Kimberly Greenberger (Analyst)
Oh, great. Thank you. Good morning. I guess I won't ask about August.
Jonathan Ramsden (CFO)
Hey, there.
Kimberly Greenberger (Analyst)
I was actually curious about inventory. I was impressed in the first quarter you were able to drive such strong revenue growth with much slower growth in inventory. I have to imagine with the increase in your costs that your unit inventories are even well below the 7.5% increase in dollars. Mike, I'm wondering if you can just talk about how you're feeling about inventories, the way they're positioned in the back half. Do you feel like you've got the inventory you need to do the volume you'd like to do?
Mike Jeffries (CEO)
I will let Jonathan answer that question. I think the answer is yes, but let him talk about it for a little.
Jonathan Ramsden (CFO)
Hey, Kimberly. Yeah, I think as we said, we feel we're appropriately positioned with fall and basic inventory. We were a little lighter in spring carryover than we would ideally have been just because of the strong first-half performance in the year. We're comfortable with where we are for fall and basic inventory. A caveat is also that the quarter end is a point in time. It's difficult to read too much into that. Overall, we're comfortable.
Kimberly Greenberger (Analyst)
Okay, thanks so much.
Operator (participant)
Our next question is Marni Shapiro with The Retail Tracker.
Marni Shapiro (Analyst)
Hey, guys. Congratulations.
Mike Jeffries (CEO)
Thank you, Marni.
Marni Shapiro (Analyst)
I'm taking seven girls to the mall later. You might want to watch your comps in the tri-state area.
Mike Jeffries (CEO)
Good.
Marni Shapiro (Analyst)
I have a quick marketing question. You talked a little bit about marketing in your opening comments. Are you changing something on the marketing side, or is the increase to support some of your international and flagship openings? Any kind of color around that would be great.
Jonathan Ramsden (CFO)
Hey, Marni. I guess it's not really oriented to international. I mean, we typically have a fairly low-key approach to international openings. It's more, you know, we've talked in the past about some of the things we're doing in social media and interactive marketing. I think you'll probably recall the presentation at the Investor Day on that. It's all those types of things that we're talking about where we're making progress, but we still think there's plenty more we can do to help drive the business going forward.
Operator (participant)
Thank you. Our next question comes from Paul Lejuez with Nomura Securities.
Paul Lejuez (Analyst)
Hey, thanks, guys. Just to follow up on Kimberly's question, what should we expect from you guys in terms of inventory at the end of the third quarter? Also wondering why the current inventory position wouldn't be somewhat of a tailwind to your gross margins, how we should think about that. Just a little bit more long-term in nature, wondering about Gilly Hicks' international opportunity. Is that something that can be a 2012 story, or are you still uncertain about the international opportunity there? Thanks.
Jonathan Ramsden (CFO)
I guess on the first foot on inventory, Paul, we would expect it to be a greater increase at the end of the third and fourth quarters. A significant piece of that is all the international store openings that we have coming into play, for which we obviously have to buy inventory to support that. I think we can't really add much more color in terms of the gross margin than we've already said. I think there are a lot of uncertainties to that. With regard to Gilly Hicks, we have a very specific roadmap on Gilly Hicks. We're making good progress against that. At this point, we're not ready to give specifics on when we would start increasing the store count in a more significant way.
Operator (participant)
Thank you. Our next question comes from Erica Maschmeyer with Robert W. Baird.
Erika Maschmeyer (Analyst)
Hi, thanks so much and congratulations.
Mike Jeffries (CEO)
Thank you.
Erika Maschmeyer (Analyst)
Could you talk a little bit more about your ability to chase into product in the fall, winter, and the actions that you're taking to chase to a greater degree than you had been? Just a quick follow-up on the increase in your number of store closures. What were the factors around that? Are the stores that you're closing still on average about $1 million of volume and kind of breaking even? Thanks.
Mike Jeffries (CEO)
Let me respond to the first part of the question. This organization is very good at chasing product, has always been. I don't think we have chased enough in the past. We have a concerted effort now to do more chasing. We're reserving more dollars for what we're calling chase, and it's working out very well.
Jonathan Ramsden (CFO)
With regard to store closures, obviously, it's a fairly modest increase from where we've previously been, and it just reflects our continual or continued sifting through all those lease expirations at the end of this year. It's skewed heavily towards Abercrombie & Fitch and kids again. In terms of volume, that $1 million average store volume for those stores is probably still a reasonable estimate.
Operator (participant)
Thank you. We'll move to our next question. Evren Kopelman with Wells Fargo.
Evren Kopelman (Analyst)
Great, thank you. Good morning.
Mike Jeffries (CEO)
Morning, Bob.
Evren Kopelman (Analyst)
In the second quarter, the 150 basis points in gross margin, can you quantify the basis points of benefit from the international mix? If you think that would be higher in the back half, and also if you expect more gross margin pressure in the third quarter compared to the fourth because, you know, the pricing doesn't really start as much in August? Thank you.
Jonathan Ramsden (CFO)
Hey, Evelyn. We haven't broken out that gross margin effect from international versus domestic. It's certainly one of the things that we're looking at, as we've spoken to in the past, how we give metrics that enable people to model the different components of the business. To this point, we have not done that. I don't think we can break out Q3 and Q4 at this point. Our outlook was for the season. As you know, things like the markdown reserve at the end of the quarter within the season can have an effect on the gross margin rate for the two quarters within the season. With regard to whether the international effect is going to be higher in the back half of the year, it should be. Obviously, we have more stores opening in the back half of the year.
I don't think I can give you any more specifics on that.
Operator (participant)
Our next question comes from Jennifer Black with Jennifer Black & Associates.
Carla White (Analyst)
Good morning. This is Carla White. I'm standing in for Jennifer Black, and let me add my congratulations on a great quarter.
Operator (participant)
Thanks. Thank you.
Carla White (Analyst)
I just wanted to talk about your new denim launch. It appears to us that you are taking a huge market share and that the denim launch was very successful. Can you talk about any planned promotions on denim that you'd have for the balance of the year? Also, can you talk to how your yoga line is doing? Could we expect to see any line extensions off of that? Thank you.
Mike Jeffries (CEO)
We can't comment on what we're going to be doing promotionally. I can't even comment on the denim promotion. I cannot tell you that it's successful or not. We'll see when the quarter's over. Yoga, I can't comment on that either. I'm sorry, Carla. Thank you for the questions.
Operator (participant)
Our next question comes from Jeff Black with Citi.
Jeff Black (Analyst)
Hey, good morning, guys.
Operator (participant)
Mike, you open with comments on Europe that, you know, the business in aggregate is doing good, which would imply some better, some worse. What's really happening across the region? I mean, are there real differences in Italy, London, Germany that you can glean? In terms of Hollister and what you've opened there, any learnings on what works better or what doesn't work as well? Thanks.
Mike Jeffries (CEO)
I think the answer is that Hollister is working every place that we've opened at, and we do not have an unsuccessful store. I believe we said in aggregate across Europe it's beating plan. I'm trying to think of a store that's under plan, but I don't want to be held to that. They are all very successful. I think the point of Hollister. is that we think it is a brand that operates well in a mall environment in many countries. That's what's been proven. We know that in Europe. We don't know that in Asia. That's why opening in Hong Kong is going to be interesting for us and mainland China.
Operator (participant)
Our next question comes from Eric Beder with Brean Murray.
Eric Beder (Analyst)
Good morning. Congratulations on a solid quarter.
Mike Jeffries (CEO)
Thank you.
Jonathan Ramsden (CFO)
Thank you.
Eric Beder (Analyst)
Now let's talk a little bit longer term with international. You're at almost 25% of your sales are international. Where do you see that going in the next 2-3 years in terms of percentage? Could you talk a little bit about the U.S. tourist-driven stores? How is their performance different from the rest of the U.S. stores? Thank you.
Jonathan Ramsden (CFO)
Eric, on the first point, we had said at the Investor Day back in April that we foresaw that international would be roughly half of the business in 2015 based on the plans we talked about for Hollister and Abercrombie & Fitch International openings. With regard to the U.S. tourist stores, I think Mike said earlier that they continue to perform well. We don't specifically break that out relative to the other U.S. stores, but they continue to do well.
Operator (participant)
Our next question comes from John Morris with Bank of Montreal.
John Morris (Analyst)
Hi. Good morning, Mike. Congratulations on a great quarter two and a great start to back to school.
Mike Jeffries (CEO)
Thank you, Mr. Jonathan.
John Morris (Analyst)
Most of the questions have been asked, but I think regarding the Canadian comments, I think you said Canada was a little bit weaker. What do you think that is from where you stand now? I think you said that you had plans to address it. If you can share some of those thoughts and just let us know what the mix of business for Canada is now.
Mike Jeffries (CEO)
Do you want to take that?
Jonathan Ramsden (CFO)
Sure. John, I think, you know, we're digging into Canada. We're not going to be too public about kind of what we think is going on. The exchange rate has probably had some impact in terms of making the differential between the AUR in Canada and the U.S. look greater, and that's probably part of it. As we said, our margins in Canada remain pretty strong. It's not a profitability issue, but the top line has been under some pressure in Canada. I don't think we want to go into detail about what we're doing to address it, but we think we have a clear path to getting that fixed.
John Morris (Analyst)
Thanks, John.
Operator (participant)
Next question comes from Omar Saad with ISI Group.
Omar Saad (Analyst)
Thanks. Good morning. Good execution this quarter.
Mike Jeffries (CEO)
Thank you.
Christine Chen (Analyst)
I wanted to follow up on Japan. If you could talk about the negative comps you continue to see there, what you think is going on in that marketplace. Does it color your view on Asia and how the brand should be positioned in other parts of Asia, or do you really feel that Japan is a unique situation and maybe macro versus company-specific issues in Japan too? Thank you.
Mike Jeffries (CEO)
First answer is that we don't believe Japan represents Asia. We'll find that out because we'll be in other Asian countries very soon. We think it is a Japanese situation. We think clearly there are macroeconomic issues and an aging population and a young population that is very infatuated with fast fashion today. We understand that. We cannot run a business in Japan that's appreciably different from the rest of the world, nor will we. We are looking at the situation in Japan just as hard as we possibly can. I think the real answer is not to believe that Japan equals Asia. We don't.
Operator (participant)
Our next question comes from John Kernan with Cowen & Company.
John Kernan (Analyst)
Hey, guys. Thanks for taking my question.
Mike Jeffries (CEO)
John.
John Kernan (Analyst)
Quickly on the CapEx guidance, what drove it to the high end of your previous range to $350 million from $300 million to $350 million? You've seen higher store build-out costs, or what changed with the thinking there?
Jonathan Ramsden (CFO)
I think we were at $350 million on the last earnings call, John, was our guidance. We had started the year low, you're right. FX was part of the increase. I think just firming up some of the store plans was the other piece of it, some additional IT investments. It was a few different pieces rather than one major piece. FX was certainly a meaningful piece of it relative to the original figure we gave.
John Kernan (Analyst)
All right. Okay.
Thank you.
Mike Jeffries (CEO)
Is no one going to ask about the situation?
Operator (participant)
Our next question comes from Pamela Quintiliano with Oppenheimer.
Pamela Quintiliano (Analyst)
I am going to ask about plans versus unplanned promotions, actually. I'm not going to ask about the situation. I'm not going to ask about August. I'm just trying to figure out, you know, you made the comment about a little bit more heightened concerns about a double-dip recession over the past few months. Clearly, you guys have been the leader, early aggressive about, you know, getting out there with the promotions and I think stealing market share from other guys. Have you been able to adjust your orders and promotions reflecting that heightened concern regarding the double dip? When you think about the customer, the core customer at each of your divisions domestically, do you think they respond to the promotions in the same way currently, or are they as sensitive to the Hollister versus Abercrombie & Fitch?
Mike Jeffries (CEO)
I really don't want to talk about the promotions in the business, Jonathan.
Jonathan Ramsden (CFO)
Are you sure you don't want to ask about the situation?
Pamela Quintiliano (Analyst)
If I get a second question, let's ask about the situation.
Jonathan Ramsden (CFO)
Sorry, although we're trying to comment. I mean, I don't think we're saying anything about the economy that is any different to anybody else. It's something that everyone is obviously more mindful of today than they were in the past. I don't think we can really speak to any specific things we're doing differently. Frankly, as we said earlier, we certainly are monitoring the situation, but we remain focused on the long-term execution of our strategy. For all the reasons Mike described earlier, we feel we're well positioned to accomplish that.
Operator (participant)
Thank you. Our next question comes from Adrienne Tennant with JANNEY Capital Markets.
Adrienne Tennant (Analyst)
Good morning, Mike and Jonathan. Mike, could you please tell us the backstory on the whole situation? That would be my first question because I am really curious. My second one really is for Jonathan. Cotton obviously is coming down. I'm not going to ask you about, kind of, you know, cost increases. At the current level of $1.03, at what point would we start to see beneficial tailwind in the financials? Like plus nine months, assuming that it crosses sometime in November. Would that put us in the back half, you know, mid to back half of 2012, theoretically? Thank you.
Mike Jeffries (CEO)
Okay. I think I can respond to the first part of your question. This is how it started. Last Friday morning, I was with a group of people here, and someone came up and said, "Mike, I have terrible, terrible news for you. Last night on Jersey Shore, the Situation had A&F products." We all said, "Oh, that's terrible. What are we going to do about it?" The group kind of came up with the solution. Let's pay them not to wear our product. That's how it happened. That's where we are, and we're having a lot of fun with it. Second part of the question.
Jonathan Ramsden (CFO)
Yeah. Adrienne, on the cotton, I think we spoke to that earlier. We would see cotton specifically, if things stay kind of where they are today, becoming a tailwind in the sort of middle part of the second quarter of next year. We got some favorable costing in the first quarter of this year before the cotton increases had really taken effect, at least for us. It started to come in much more significantly in the second quarter and through the back half of the year. If everything stayed the same today, then we would expect that to become a tailwind in the middle of the second quarter of next year. As I said earlier, there are still other inflationary pressures which aren't fading or turning, most notably labor costs.
Operator (participant)
We will go to our next question from Linda Tsai with ITG Investment Research.
Linda Tsai (Senior Analyst)
Good morning. In your press release, you mentioned a higher AUR on international benefit. Was the AUR positive for all the brands? You also mentioned graphic images being a little bit weaker across the brands. Was it an issue of newness?
Jonathan Ramsden (CFO)
We can barely hear you.
Linda Tsai (Senior Analyst)
Okay. Can you hear me better now?
Jonathan Ramsden (CFO)
I think it's better. Yeah.
Linda Tsai (Senior Analyst)
I was saying, in your press release, you mentioned a higher AUR in international mixed benefit. Was the AUR positive across the brands? You also mentioned graphic images.
Jonathan Ramsden (CFO)
Sorry, Mike. On the AUR, Linda, what we said was that our AURs were up both domestically and internationally. Internationally, that's obviously on a constant currency basis. Overall, we were up mid-single digit for AUR. We don't break that out by brand, so there's not really anything additional I can tell you on that piece.
Mike Jeffries (CEO)
I think your question about the graphic tees is a good one. We planned decreases in graphic tees because we're consciously trying to push more fashion in the business and less reliance on logo. That's one of the thrilling things that's happening in the business. It's working.
Operator (participant)
We will go to our next question. Robin Murchison with SunTrust Robinson Humphrey.
Robin Murchison (Analyst)
Thanks, and good morning.
Jonathan Ramsden (CFO)
Morning, sir.
Lorraine Hutchinson (Retail Analyst)
I wanted to ask about your directionally, and I know it's very early, but directionally about CapEx for the out year. Presumably, haven't you kind of come through a lot of the larger flagship Abercrombie & Fitch stores? The forward stores might be somewhat smaller, a little less costly, or any cash flow info would help.
Jonathan Ramsden (CFO)
Yeah. Hey, Robin. If you look in terms of total count, we've spoken in the Investor Day to the fact that our rate of Hollister openings, we would be looking to accelerate that further beyond the 2011 level. The level of flagship openings we were targeting for 2012 would be higher than 2011. I think taking into account those two factors, they would drive CapEx up beyond the 2011 level. Other CapEx not related to stores would probably be less significant in terms of the year-over-year change. To your point, though, it is still very early in the process for 2012 CapEx, and we'll certainly be giving more detail and color on that at the end of the year.
Operator (participant)
Thank you. Our next question comes from Barbara Wyckoff with CLSA.
Barbara Wyckoff (Analyst)
Hi, everyone.
Jonathan Ramsden (CFO)
Hey, Barbara.
Barbara Wyckoff (Analyst)
Good job. Hi. Two questions. Are there going to be, of the 34 Hollister stores that are opening this fall, are any of those in Asia outside of Festival Walk Mall? That's number one. Number two, you know, Mike, looking back, if you could do over the second quarter, what would you have done better? I know it was a great quarter, but flow, inventory classifications, just sort of thinking about how it played out. Thanks.
Jonathan Ramsden (CFO)
Hey, Bob. Just on the first one, yes, we do have other Hollister openings in mainland China, which we spoke to earlier on, which are part of the count of close to 40 for the year.
Barbara Wyckoff (Analyst)
How many?
Jonathan Ramsden (CFO)
Yeah, we're giving that number, but it's a couple.
Barbara Wyckoff (Analyst)
Okay. Thanks.
Operator (participant)
Our next question comes from David Weiner with Deutsche Bank.
Mike Jeffries (CEO)
Sorry.
David Weiner (Analyst)
Oh, yeah. Good morning, everyone. Two quick questions. Number one, on international mall rents, just curious, we've heard that sequentially over the last couple of quarters, the rents are starting to tick up after being down for a while. If you could just kind of talk about relative to your 475 plan, if you know kind of what you're seeing in the mall rent trends into next year internationally, is it kind of in line with what you thought? That was really my only question. Thanks.
Jonathan Ramsden (CFO)
Yeah, I guess with regard to rent, it all comes back to how we look at each of these deals internationally. It all comes back to that target four-wall margin of 30% for Hollister and typically a little bit higher for Abercrombie & Fitch that we're shooting for. We look at the overall economics of the deal, the CapEx we have to spend to build the store, the rent. If we feel we can get that acceptable overall return, we typically go forward with the store. I can't really speak to what's happening with individual rents, but we're obviously looking at each deal on a deal-by-deal basis and making sure it meets our criteria.
Mike Jeffries (CEO)
I would have to add that with our success in Europe, we're a very much in-demand tenant.
Operator (participant)
Ladies and gentlemen, that does conclude today's question-and-answer.