Tapestry - Earnings Call - Q3 2011

Transcript

Speaker 6

Good day and welcome to the Tapestry Conference call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to Senior Vice President of Investor Relations and Corporate Communications at Tapestry. Ms. Andrea Shaw Resnick, you may begin.

Thank you. Good morning and thank you for joining us. With me today to discuss our quarterly results are Lew Frankfort, Chairman and CEO, Mike Devine, CFO, and Victor Luis, President of International Retail, who will report on our Asia direct opportunity. Before we begin, we must point out that this conference call will involve certain forward-looking statements, including projections for our business in the current or future quarters or fiscal years. These statements are based upon a number of continuing assumptions. Future results may differ materially from our current expectations based upon risks and uncertainties, such as expected economic trends or our ability to anticipate consumer preferences. Please refer to our latest annual report on Form 10-K for a complete list of these risk factors. Also, please note that historical growth trends may not be indicative of future growth.

Now, let me outline the speakers and topics for this conference call. Lew Frankfort will provide an overall summary of our third fiscal quarter 2011 results and will also discuss our strategy going forward. Victor Luis will speak to our Asia direct businesses, providing an update on China and other markets in the region. Mike Devine will continue with details on financial and operational results of the quarter. Following that, we will hold a question and answer session where we will be joined by Mike Tucci, President of North American Retail. We'll end the Q&A shortly before 9:30 A.M. Lew will then conclude with some brief summary comments. I'd now like to introduce Lew Frankfort, Chairman and CEO.

Speaker 3

Thanks, Andrea, and welcome, everyone. As noted in our release this morning, we were very pleased with our quarterly results, including store sales and earnings growth and the continuation of excellent comparable store sales in our North American retail businesses. Our performance clearly demonstrates the brand's vitality across channels, geographies, and bodes well for the future. Further, the ability to generate these results in light of the tragic events and their aftermath in Japan speaks to the diversification of our business model and the strength of our brand proposition globally. Beyond the top line, we were also very pleased with our high levels of profitability and substantial cash generation. In addition, we make continued progress against our global business initiatives, including international expansion, MENS, and digital media. We experienced a strong response to our new collections, and our pricing and assortment strategy continues to resonate with consumers worldwide.

We're well situated to build upon our leadership position and continue to gain market share. Further, the announcement today of the increased dividend reflects our financial strength and our confidence in Tapestry Inc.'s future. Before I review the quarter and provide an outlook for the category and our business, I would be remiss not to touch on the tragedy in Japan. Of course, we have been saddened by the devastation in Japan, but we're relieved to learn within days of the earthquake and tsunami that all Tapestry Inc. colleagues were accounted for and safe. When I visited Japan in early April, I was impressed by the resiliency of the people and the progress made in restoring more normal conditions. I was moved by the incredible spirit and tenacity of our own Tapestry Inc. Japan colleagues who rallied together during a very difficult time.

Moving on to some key highlights of our third fiscal quarter. First, earnings per share rose 23% to $0.62, compared with $0.50 in the prior year. Second, quarterly net sales totaled $951 million versus $831 million a year ago, an increase of 14%. Third, direct-to-consumer sales rose 15% to $832 million from $726 million in the prior year. Fourth, North American same-store sales for the quarter were robust, rising 10% from prior year, while total North American direct-to-consumer sales rose 16%. Fifth, sales in Japan were down 9% to prior year in constant currency and rose 1% in dollars. Finally, we continue to generate very strong sales growth and significant double-digit comps in China. During the quarter and the start of our regular real estate review, we closed three North American retail stores while we opened five factory stores.

At the end of the period, there were 344 full price and 134 factory stores in operation in North America. Moving to Japan, four locations were opened and one was closed. At quarter end, there were 174 total locations in Japan with 19 full price stores, including eight flagships, 119 shop and shops, 29 factory stores, and seven distributor-operated travel retail locations. As noted in our release, seven stores in the Sendai area remained closed due to damage at quarter end, with three reopened this month. In China, we added four new locations, all in the mainland, and closed one store in Hong Kong. At the end of the quarter, there were 55 Coach locations in China, including nine in Hong Kong, two in Macau, and 44 locations on the mainland in 18 cities.

As we discussed previously, there are nearly 120 cities in China with a population of 1 million or more, and we are building a multi-channel distribution model with a focus on the mainland to leverage this opportunity. Indirect sales increased 14% to $119 million from $105 million in the same period from last year. This gain reflected significant growth in shipments into international wholesale and U.S. department stores, given positive POS sales trends in both businesses. Specifically, sales for the quarter in retail and international wholesale locations were strong, driven by new distribution, while sales at POS and U.S. department stores rose 12% for the quarter. We estimate that the addressable U.S. handbag and accessory category rose at a 5% to 10% rate in the third quarter, similar to the increase it experienced in calendar year 2010.

At the same time, Coach's bag and accessory sales rose about 13% across all channels in North America during the most recent quarter. In our direct businesses in North America, handbag and accessory sales rose 17%. We continue to estimate that the category will increase to $9 billion this year, surpassing its previous peak achieved three years ago. Separately, it's worth noting our customers' outlook for the economy has been stable over the last few quarters, with a third of those surveyed still believing that the U.S. economy is improving. Her intention to purchase Coach remains high, with over two-thirds of consumers surveyed noting they probably or definitely would purchase a Coach product in the next 12 months. Our total revenues in North America rose 16%, with our directly operated businesses up similarly, driven by 10.3% in same-store sales increases and new distribution.

Fueling these overall strong comp results were similarly strong gains in both channels, with significant gains in conversion from prior year and a modest growth in average transaction size, partially offset by a decline in traffic due to the calendar shift. We were particularly pleased with the improvement in conversion rate since it's the driver that we have the most control over through product and service. We have also been delighted by our traction on the web, notably the North American coach.com business. While we view this channel primarily as a marketing vehicle, traffic and sales at our site continue to grow at a double-digit pace during the third quarter, driven by our base business as well as our efforts in social media, where we now have over 1.8 million Facebook fans.

Additionally, next month, we're looking forward to the launch of mobile commerce in North America, another digital platform for customers to engage with our brand. As noted in Japan, we posted a 1% increase in dollars and a decline of 9% in constant currency. It's worth noting that prior to the events of March 11, we were on track to deliver another quarter of light growth in yen terms. Our market share further expanded against continued contraction in the category. Once again, I want to call out China, our fastest growing business. During the quarter, our sales continued to rise rapidly from prior year, fueled by distribution growth and significant double-digit comps. Clearly, the Coach proposition is resonating with this consumer who is participating in this category in increasing numbers. Victor will talk more about our opportunity in China shortly.

Across all full-priced businesses, our robust results reflect the strength of our offering. As always, we maintained a high level of product innovation and distinctive newness. Beginning on December 24, we transitioned to spring with the introduction of the Colette collection, offered across multiple fabrications and silhouettes anchored by both our Hobo and Tote styles. This was followed by the relaunch of Poppy in February and the new Kristen collection in March. With its distinctive hardware and soft feminine styling, Kristen is an important collection for Coach and has been a feature of our spring ad campaign. This season's product was very well received, and both handbags and women's accessories achieved strong comps in the quarter, with handbag penetration in our North American retail stores rising to 60% from 59% last year, driven by unit comp sales increases and a slight increase in average unit retails.

Just this month, we introduced the collection of Natalie novelty store totes, along with new colors in the Dream C print and Poppy. Last week, we launched Audrey, a modern tote story featuring perforated leather, Op Art and print concepts. Additionally, our leave collection for Mother's Day of Madison offers fresh colors and patterns. For June, we're introducing new leather and pattern colors at Kristen, as well as a strong new Op Art print. Our Kristen Hobo continues to be the key item within the collection. In addition, this July, we will launch a new Chelsea collection and evolve Poppy with updated styles, patterns, and prints. On the factory side, the strong results were fueled by a powerful combination of new product introductions with key styles offered at great prices. Additionally, our inventory investment strategy enabled us to capture sales upside throughout the quarter.

Our product assortment was also supported by our in-store and direct marketing campaigns. I also wanted to spend a moment on MENS, which continues to be very pleased with our results in all retail stores, which carry a broader MENS assortment, as well as our dedicated MENS shops in Japan and our New York City concept store. We look forward to opening two additional MENS retail stores over the next few months in North America, including one at Garden State Plaza in New Jersey and one at Copley Plaza in Boston. On the factory side, our MENS stores, which are located next to or nearby our most productive factory locations, are performing extremely well. We believe the strong consumer response we're experiencing reflects the strength of the Coach brand and the factory consumer's focus on value and function.

It confirms our belief that there is a particularly large opportunity for MENS in our factory channel. In summary, we're excited with the continued progress we've made in improving our overall full-price productivity. In addition, we're very pleased with the current sales trends in both our full-price and factory channels and are well positioned for Mother's Day and a balance of the spring season. Our strategies continue to be focused on expansion opportunities both here in North America and increasingly in international markets. In addition, as always, we are focused on improving performance in existing stores by increasing Coach's share of our consumers' accessories wardrobe, while continuing to attract new customers into the franchise. I just discussed our MENS initiative, which we're confident will be a significant contributor to global growth in the seasons and years ahead. Moving on to distribution growth.

As mentioned in previous earnings calls, we expect that our square footage globally and across all channels will increase about 10% this year, compared to 8% last year. Starting in North America, we will open three stores in the fourth quarter of fiscal 2011, bringing the total to eight new North American retail stores for the year. In addition, we will open nine new factory stores during a balance of the year, primarily to support our MENS initiative, bringing the total to 14 dedicated MENS factory stores and eight traditional factory stores for the year. In total, we expect North American square footage growth of about 8% this year. I want to finally touch on a new region of expansion for Coach.

To date, we have opened seven boutiques in Printemps department stores in France, and through our JV with Hackett, we launched the brand with four shop and shops in Spain and one in Lisbon, with one more to go before year-end, all within El Corte Inglés. Last month, we opened our first retail store in the UK in the Westfield White City Mall and have been very pleased with its early results. Beyond the opportunities in the Coach concept and brand, as you know, we launched Reed Krakoff in September and a few boutiques in the U.S. and Japan, as well as through prestigious international specialty retailers. While still very early days, we are pleased that the product is appealing to the targeted pinnacle luxury consumer.

We were very pleased to announce the appointment of Valerie Hermann as President and CEO of Reed Krakoff, who joined us just this month from YSL. Earlier this fiscal year, we announced the creation of a new international retail organization with three major Asian hubs: Japan, mainland China, and other Asia markets. We also announced the addition of three senior executives who will enable Coach to capitalize on the significant growth opportunities that exist for the brand in the region. Key to this new organization was the promotion of Victor Luis to the newly created position of President of Coach Retail International, with the responsibility for all of Coach's directly owned businesses outside North America. I will now turn the call over to Victor. Victor?

Speaker 5

Thanks, Lew. To put the opportunity in perspective, the premium bag and accessory market in Asia, including Japan, is nearly $12 billion today. In contrast to the global market, which is about 85% women's and 15% men's, in Asia, men's represents nearly one quarter of the spend. Excluding Japan, the market is growing at a double-digit rate led by mainland China. In addition, Hong Kong, Korea, and Southeast Asia are all expected to grow at more than 10% for the next several years, while Taiwan is projected to grow at a slightly slower pace. Overall, the region offers excellent potential where we can leverage our well-honed retail skills and international experience to drive the business, as we have done in Japan and are now doing in China.

Coach is already among the top five brands in these markets with at least a mid-single-digit share, and we have proven strategies in place to increase brand awareness and grow sales. In Japan, the overall consumer market has been challenging for some years, and the category has contracted. Our goal was and continues to be market share gains, and we have done this quite well in our core women's business. As elsewhere, we're now also focusing on men's, where we've already seen early success. As Lew noted earlier, we do expect a continued impact from the tragedy over the next few months, primarily a function of reduced traffic as the infrastructure problems in the northern and eastern parts of the country remain, resulting in transportation and power issues. However, barring further significant aftershocks or worsening of the nuclear crisis, we expect our business to continue to show steady improvement.

We expect to open two more stores in the fourth quarter for a total of nine new Coach Japan locations, including five men's stores for the year. In total, we expect the net square footage growth in Japan will increase by about 4% this year, similar to last year. Moving on to China, our largest geographic growth opportunity, where our sales are growing rapidly against a strong market backdrop. We will be adding 11 locations in the fourth quarter, nine on the mainland and two in Hong Kong, taking us to 26 openings for the year and a total of 66 locations. As you know, we doubled sales in FY2010 to over $100 million and are now on track to generate sales of about $185 million this year, up from our estimates of $175 million shared on our last earnings call.

We are targeting a 10% market share of what is projected to be over a $5 billion market or about $500 million in sales by FY14, up from about a 5% share today. Driving this growth, we expect to add about 30 new locations per annum during our planning horizon, focused on the mainland and across a multi-channel model, including flagships, standalone retail stores, shop in shops and department stores, and factory stores. In addition, based on our conversion opportunity against already strong traffic trends, as the consumer becomes increasingly qualified to purchase luxury accessories, we expect to continue to achieve double-digit comp rates over this planning horizon. In fact, our research indicates that the purchaser population is growing at nearly 20% annually, driven by the growth in the target segments, primarily through income gains and the increasing participation rate in the category itself.

We would also note that in China, men participate heavily in the category, both for self-purchase and for gifting to other men, and represent nearly half of the spend and up to 50% or more of our competitive set sales, yielding another opportunity for Coach. Further, as we grow awareness in China, we benefit globally from the growth in mainland China tourists as they visit and shop in key capitals around the world. In fact, we estimate that sales to mainland Chinese nationals represent as much as 25% of sales globally to our major competitors. Today, sales to Chinese nationals represent only 5% of Coach's global sales. Therefore, there is tremendous opportunity for us to take a larger share of a growing market where our proposition is clearly resonating and where building our distribution team and awareness will lead to continued growth.

As you may remember, China is the market where Coach enjoys its highest repurchase intent among existing consumers, with over 90% of Coach shoppers expressing a positive intent to repurchase. In FY12, we will make significant investments towards awareness building as we leverage a 70th anniversary campaign as a foundation to build on our positioning as a New York fashion brand grounded in heritage and history. This integrated campaign will have several key elements, including an international brand ambassador, Gwyneth Paltrow, who has proven relevancy in China and other international markets. Beyond our directly owned business in China, we have significant wholesale businesses throughout Asia, and Lew referred to the strong sales growth we're experiencing in this channel earlier.

Some months ago, we announced that we've signed an agreement to take control of our domestic retail businesses in Singapore and Malaysia, which together generate annual sales at retail of about $50 million. The agreement provides for a phased transition of the current Coach retail businesses over the next year, beginning this July with Singapore. While the impact of the transition will be small, it is an important step towards controlling our future in Asia. We are especially excited about a new Singapore flagship on prestigious Orchard Road, which will be a directly operated store opening in spring 2012. It will immediately raise brand awareness as Singapore is an important tourist gateway in Southeast Asia, serving the Indonesian and Indian shopper while increasingly attracting mainland Chinese consumers as well.

We also have significant and growing distributor-run businesses in Korea, the second largest market for premium leather goods after Japan in the region, and Taiwan. Together, they represent about $200 million at retail for Coach in FY11, serving both the domestic and travel retail customer through about 80 locations, over 50 in Korea and 30 in Taiwan. Given our focus in the region during this fiscal year, of the nearly 40 targeted new international wholesale locations, more than 20 will be in Asia. Separately, it's important to note that our Asia distribution center and Asia shared services center are online, shipping globally, and prepared to provide savings while also serving as a back office backbone for Coach China, Hong Kong, Singapore, Malaysia, and any future directly operated markets in the region. Simply put, it is ready to be scaled for leverage across the region.

In summary, we are excited about the global opportunity for Coach, especially the emerging market potential given the rapid growth of the category and the foundation which we have begun to build in the key Asia region. At this time, I will turn it over to Mike Devine, our CFO, for further details on our financials.

Speaker 1

Thank you, Victor. Lew and Victor have just taken you through the highlights and strategies. Let me now take you through some of the important financial details of our third quarter results. As mentioned, our quarterly revenues rose 14%, with direct-to-consumer, which represents over three quarters of our business, up 15%, and indirect up 14%. Earnings per share for the quarter increased 23% to $0.62 as compared to $0.50 in the year-ago period, as net income rose to $186 million from $158 million. As noted in the press release, we estimate that the events in Japan impacted sales by approximately $20 million and earnings per share by about $0.025 during March and the third quarter. On a non-GAAP basis, our operating income totaled $280 million in the third quarter, up 12% from $249 million in the same period last year.

Operating margin in the quarter was 29.4% compared to 30% even in the year-ago period. In the third quarter, gross profit rose to $692 million from $616 million a year ago, and gross margin rate remained strong at 72.8% compared with 74.1% a year ago, reflecting the impact of higher sourcing costs. Moving to expenses, we were pleased that we were able to gain 70 basis points of leverage in the quarter. Specifically, SG&A expenses as a percentage of sales, also on a non-GAAP basis, improved from prior year levels in the third quarter and represented 43.4% of sales versus 44.1%. Once again, our primary direct businesses here in North America and in Japan provided leverage to the corporate P&L, more than offsetting the impact of our investment spending. We believe we're striking the right balance between driving future growth opportunities and operating efficiencies.

As noted in our press release, we recorded certain one-time items during the third quarter, which resulted in a substantially lower tax rate of 26.5%. These included a favorable settlement of a multi-year tax return examination, which decreased Tapestry Inc.'s provision for taxes by $16 million. In addition, the company made a $21 million contribution to the Tapestry Foundation and also contributed ¥400 million, or just under $5 million, to the Japanese Red Cross. Together, these contributions totaled nearly $26 million pre-tax, impacting GAAP SG&A expenses by that amount and precisely offsetting the benefit of the tax settlement to net income and EPS. Moving on to the balance sheet, inventories at quarter end were $391 million, up 28% from the end of last year's Q3, but up 9% on a two-year basis. Our current inventories support the strong underlying business trends and will allow us to maximize sales this spring.

Generally, it's worth reminding everyone that we've been right-sizing our inventory this year, bringing it up to more appropriate levels to support our growth, including new initiatives such as MENS, global square footage expansion, our new distribution center in Asia, and other strategic investments. Cash and short-term investments stood at $886 million, as compared with $908 million a year ago, despite repurchases of nearly $1.2 billion worth of Tapestry Inc. common stock in the interim 12 months. During the third quarter, we repurchased and retired three and a half million shares of common stock at an average cost of $54.51 per share, spending a total of $192 million. At the end of the period, approximately $1.3 billion remained under our repurchase authorization. Net cash from operating activities in the third quarter was $227 million, compared to $205 million last year during Q3.

Free cash flow in the third quarter was an inflow of $186 million versus $190 million in the same period last year due to higher net income offset by working capital and fixed asset expenditures. Our CapEx spending was $42 million versus $15 million in the same quarter a year ago. As we stated on our last three earnings calls, based on our plans for the year, we expect that CapEx will be about $150 million, primarily for the opening of new stores across all geographies. Naturally, we were very pleased to report these strong financial results, and as Lew has said, we're well positioned for the remainder of the fiscal year. While we do not give specific guidance, as you know, I always think it's helpful for you modelers out there to keep a few things in mind when forecasting the finish of our year.

First and most generally, we continue to target double-digit sales increases globally with double-digit earnings growth. Given the ongoing strength in our business, we now believe that we'll achieve high single-digit same-store sales growth in North America for the fourth quarter, even in the face of more difficult compares. Additionally, we expect the continuation of our positive POS trends in our indirect business. As noted in our release, given current conditions and projections for Japan, we expect a similar impact in the full fourth quarter of about $20 million or 2% to total Coach sales and about $0.02 to $0.03 to earnings per share. However, as discussed on prior calls, our fourth quarter comparisons will be impacted by the timing of shipments in our indirect businesses and the extra week in the prior year's fourth quarter.

As you may recall, this extra week contributed $70 million of sales and $0.08 of EPS to last year's Q4. Second, we were excited that our top-line sales growth drove higher levels of profitability in the first nine months of the year. While our previous comments regarding gross margins still stand, our sales growth, coupled with controlled spending, will help offset both cost and channel mix pressures. Therefore, we're reiterating our previous guidance of a full-year FY2011 operating margin at about last year's levels of about 31.5% on a 52-week basis, despite the quake-related shortfall in our very profitable Japan business. Third, our non-GAAP tax rate is likely to stay in the area achieved in the first nine months for the balance of the year as we further refine our international tax strategies. Fourth, I did want to update our share count guidance.

We now believe that our fourth quarter average will be similar to Q3 at about 302 million on a fully diluted basis. Before we open it up for Q&A, I want to echo Lew's earlier words. This was another excellent quarter for Coach. Clearly, our results bode well for the future, and we're confident that we'll continue to deliver very strong sales and earnings gains for the foreseeable future. Thank you all for joining us on our conference call today. Now Lew, Victor, Mike Tucci, Andrea, and I will take some questions, which will then be followed by a brief comment from Lew, who is, I'm sure you can tell, suffering from a touch of laryngitis but is hanging in boldly. Now we'll open the floor up to questions. Thank you.

Speaker 6

Thank you. At this time, if you would like to ask a question, please press star one on your touch-tone phone. To withdraw your request, you may press star two. Once again, to ask a question, please press star one. Our first question comes from Bob Durbell with Barclays Capital. Please go ahead.

Speaker 2

Hi, good morning.

Speaker 1

Good morning.

Speaker 2

I'd like to ask the team a question about China. I really spent a lot of time on it. Can you size the opportunity longer term? Do you think it can be bigger than your North American business? Can you address any goals or your thinking around the profitability of that region, you know, near term but even longer term?

Speaker 3

Why don't I begin and then turn it over to Victor? First, Bob, the opportunity in China is boundless. It's still early days. Our market share is only in the area of 5%. Our category is growing rapidly. We like to set reasonable milestones. Our first challenge is for China to surpass Japan, which today is over $700 million U.S., and China this year, as we reported, will do about $185 million. For it to actually eclipse the U.S., we will need to become the number one brand in China at a time when the China accessories market is large enough to support such sales. Is it something that might occur? Perhaps, but in the end, we have a long way to go. Victor?

Speaker 5

Sure. I would add that today we're looking at a market in China that's approximately $3.2 billion, including travel retail, which we expect to grow to approximately $7 billion by FY2015, already larger than Japan, which today is approximately $4 billion. As Lew mentioned, we today are over $700 million in sales. We do see tremendous growth in a market where, as Lew mentioned in his remarks, we have at least 120 cities with a population of a million or more and truly tremendous opportunity in terms of distribution as well. China is developing as a wonderful market for multi-channel distribution, both in department stores where we have tremendous opportunity.

There are today approximately 600 department stores in China, of which approximately 100 of them already have luxury cosmetics, with sales approaching the top 100 department stores in Japan as another great measure, as well as a rapidly developing shopping mall and slowly but surely developing factory outlet mall channel, which will be another terrific opportunity for us. We are truly excited, and I would echo Lew's comments that we do feel the opportunity to truly be boundless. I'll turn it over to Mike for some comments on profitability.

Speaker 1

Yeah, Bob, as you've heard us say many times on these calls and in other forums, we're very excited about the level of profitability we feel the China business can achieve for a couple of fundamental reasons. Firstly, we do sell through at a premium to North America pricing in the region, not premiums as rich as Japan's, but in the neighborhood. Our gross margin rates in China are quite robust, rivaling even that of the Japan business. In terms of store four walls, we're already seeing four walls nicely into the 40% range. That's driven, of course, by that gross margin rate. Also, as you might suspect, our store wages are lower in China than they are anywhere else in the world, contributing to a healthy four wall.

As we gain in productivity and the brand gains awareness with landlords, we'll see our occupancy rate, the other big expense item on a store P&L, begin to decline as a percentage of sales, further enhancing store four walls. Victor mentioned in his prepared remarks our approach to the region with an Asia distribution center and an Asia shared service center. We're keyed to drive an efficient back office infrastructure to support both the China business and the Pan-Asian approach. All of those things taken together, a lot of words, will drive very, very healthy rates of profit and volume of profits from the region as we move into 2012 and beyond.

Speaker 3

Thank you, Mike.

Speaker 2

Mike, I just have one quick follow-up. On the $0.025 hit from Japan this quarter, can you give us an estimate on how detrimental Japan was to the gross margin that you reported this morning?

Speaker 1

Yeah. To be helpful, Bob, clearly with Japan being one of our highest gross margin regions, losing that $20 million was hurtful to the gross margin rate, but relatively immaterial. We certainly would have recorded a modestly higher gross margin rate, but it is a small percentage of the total company's business, and we were able to absorb it. I would add, though, I have to take this opportunity that had we had that $20 million of sales and about $0.025 of earnings, we would have actually seen operating margin leverage. You know, we did come up just short of Q3's op income level. Had we had the $20 million of that very profitable Japanese business, we would have seen operating margin improvement, which I have to say, coming into the quarter, I did not think was going to be possible.

The business operated very efficiently across all geographies and matured businesses during the quarter. Similarly, I would just say for the fourth quarter, same dynamic in our own projections that we've just kind of shared with you. We will see some very modest operating margin deleverage for the quarter. We would have gotten operating margin leverage had we not had the quick impact. Of course, these are all forward-looking statements now to talk about fourth quarter. I do think it demonstrates the diversity of our business model globally that we're able to absorb this profitable loss and still project that we can hit 31.5% op income for the year, kind of what we've been pointing to for a number of quarters now. In a way, I'm thinking about that as an increase in guidance, if you will, adjusted for the quick impact.

Speaker 2

Thanks very much.

Speaker 6

Thank you. As a reminder, please limit yourself to one question. Our next question comes from Kimberly Greenberger with Morgan Stanley.

Speaker 7

Oh, great. Thank you. Congratulations on a nice quarter.

Speaker 1

Thank you, Kimberly.

Speaker 7

I'm wondering if you can talk about your outlook for sourcing cost inflation and the pricing strategies as you look into the back half of calendar 2011. Mike, if you could just remind us about your gross margin outlook here for the remainder of the calendar year, that would be helpful. Thanks.

Speaker 1

Sure. Kimberly, we're essentially in the same place on gross margin as we have been in terms of our guidance for the balance of FY11. You'll recall that we were one of the first companies to talk about inflationary pressures well over a year ago, and that's holding. That being said, there are a number of positive things going on within gross margin to help offset these pressures. We're guardedly optimistic that we'll see some modest sequential improvement, actually, in the first half of our FY12, the back half of this calendar year, versus the second half of our FY11. It's because of countersourcing efforts. Material inflation will not hit us as hard as others. The other thing that will be helpful is we'll also begin to anniversary those higher input costs from early last year's fiscal 2011.

Wage inflation is our biggest issue, and we're battling that by moving product into lower cost countries. We're ahead of schedule on this initiative, but it is still very early days there. While we are protecting our opening price points, we are also surgically taking advantage of pricing power, and we're doing this in both channels, both in our full price and our factory channel. The other thing we'll start to see, which will be very helpful, is channel mix will actually begin to help us, we believe, as we move into FY12, which will be a nice thing as growth in the Asia region that Victor spoke to helps channel mix there. Also, just the underlying trends in our full price business in our mature markets of North America and Japan will also help channel mix. We still are feeling good about our previous guidance.

Gross margin in the boundary of 72% to 73% going forward, we feel are very achievable.

Speaker 7

Thanks, Mike. Is it helpful at all that global automobile production is expected to fall short this year of the prior expectation? I think that the auto industry is one of the largest consumers of leather.

Speaker 1

That's a very good point, Kimberly. It is a supply and demand equation, of course, as you would imagine. If demand is down, that will certainly help buyers of leather. Our team has done an amazing job countersourcing, and leather is not a big driver of our inflationary cost pressure, especially year over year. The issue you bring up will be helpful to us, but somewhat immaterial to the total reported gross margin with all the other factors that impact it.

Speaker 7

Great. Thanks and good luck here.

Speaker 6

Thank you. Our next question comes from Neely Tamminga with Piper Jaffray.

Speaker 7

Good morning. Let me also add my congratulations on a great quarter. Victor, thanks for joining the call. I was just wondering if you could walk us through a little bit more on some of the evolution of this company as you go from just being primarily two geographies to multi-geography. Clearly, you spoke to the back office aspect of some of the shared services, but could you give us a sense again and just let us know how you guys are designing for the different geographies and buying from those lines? Are you doing like a global design and then having regional people purchase towards the preferences of each individual consumer? Just help us understand that a little bit more as the company continues to clearly grow globally. Thanks.

Speaker 5

Sure. As you all know, of course, we have one design team, which is based here in New York, and that design team does design globally. In each of our geographies, we have in-market merchants who constantly, with the support of our consumer insights team, are looking to understand the consumer and provide the design team with some logic to add to the magic that they, of course, do in designing the product. We have a very strong merchant team in Japan. We have today a merchant team in Shanghai, as well as Hong Kong that is developing. Those teams provide the inputs into New York and then will buy from a global assortment, which occasionally, of course, is tweaked to meet local needs. On the whole, though, I would say that our assortments are rather global.

In Japan, China, collections such as Madison, Poppy, and Kristen, which are today the main drivers in the North American business, are also main drivers for us in the region. There may be some functional areas that we have to tweak, whether it be in small leather goods or in handbags. As an example, in handbags across Asia, cross-body bags, given the amounts of commuting that take place, do tend to have a higher penetration than, say, here in North America. That is something that we simply input into our buys locally. I think one of the most important differences, as I mentioned in my remarks, is the MENS opportunity. In Japan, the MENS market of that $4 billion size today represents approximately 20%. In mainland China, it can represent 50% or more for most of our competitor brands and is approaching about 50% of the markets.

Getting to Hong Kong, Macau, and the rest of the region, we're looking at 25% to 30% as well. Our in-market merchant teams are working very, very closely with our central merchandising teams and our design team to ensure that those very specific needs of that specific Asian male consumer are met. It is a highly collaborative effort with a tremendous amount of consumer insights, as well as, of course, the design talents, which is very much focused on presenting one New York Coach aesthetic to the world based here in New York.

Speaker 7

That's really helpful, Victor. Thanks and good luck, and feel better, Lew.

Speaker 1

Thank you.

Speaker 6

Thank you. Our next question comes from Lorraine Corrine Maikis Hutchinson, Bank of America Merrill Lynch.

Speaker 0

Rick Patel in for Lorraine. Can you just update us on your mix of handbags priced below $300? Do you feel this mix is appropriate today, given what you're seeing in the marketplace? How should we expect that to change over time?

Speaker 5

Sure. As you know, we've been very dedicated to this overarching $300 price positioning. Our handbag under $300 penetration and offer is right at about 50%. We see that as being a really important level for us. We also see some trend growth happening in leather, which is impacting price point, gives us an opportunity to nuance some of our pricing in a positive way. There's some margin opportunity there. We had very, very nice growth, incidentally, in handbags over $400, where that penetration went to about 18% versus 10% in the prior year. That's a big deal and driven very much by this leather trend that we're seeing. I think just to add a sense or two on factory, very similar trends there, strong leather trend.

We had a very nice AUR increase in handbags in the factory business while maintaining what we think is a competitive positioning in that channel.

Speaker 0

That's helpful. Thank you very much.

Speaker 6

Our next question comes from Christine Chen, Needham & Company. Please go ahead.

Speaker 7

Thank you and congratulations on a good quarter.

Speaker 1

Thank you, Christina.

Speaker 7

I wanted to ask about your factory business. Your factory channel seems to be really clean of full-price inventory. Wondering what the percentage of factory-specific factory exclusives was in the quarter versus last year. Also, wondering about footwear. What is it as a percentage of your total? Is it driving the increases at the department store level, or is it pretty equal between bags and footwear there? Thanks.

Speaker 5

Christine, I think you're breaking up a little bit, but the essence of your question was around mix of product and factory, where we saw, again, a very, very strong contribution from factory exclusives. Terrific response to Nunitz there. The level there was 86%. That's been a running average for us in about that zone. It affords us pricing and margin flexibility there. We see that continuing. Our footwear business is very good, stable. We don't have a significant footwear business in our factory channel, but on the full price side, our footwear business continues to be positive.

Speaker 7

What about at the department store level?

Speaker 5

On the department store side, our footwear business has also been healthy. We haven't seen account growth there, but we're very much focused on what we see as an assortment productivity opportunity in the wholesale channel, and that has been very successful for us this spring.

Speaker 1

We enjoy about 5% market share in that channel.

Speaker 7

Have you been able to pull back on some of the promotions at factory?

Speaker 1

I'm sorry.

Speaker 6

Christine, we're unfortunately losing you, so maybe we can catch up on your follow-up questions after.

Speaker 7

I'm sorry. I said, were you less promotional with the factory channel?

Speaker 5

In fact, our margins in factory were slightly better, and our promotional levels were pretty much even with the year prior.

Speaker 7

Great. Thank you and good luck.

Speaker 6

Thank you. Our next question comes from David Schick, Stifel Nicolaus. Please go ahead.

Speaker 0

Hi, good morning.

Speaker 1

You're welcome.

Speaker 0

When we hear about 40% plus, I think you said, four-wall contribution in China, and that's the fastest growing business you have, it feels like MENS is not, you know, it's partially what Coach is doing around MENS, but also maybe a growing global marketplace for MENS or demand for MENS. We look back at what you've done margin-wise. How should we operate margin-wise? What should we think about for operating margin, you know, five or seven, you know, not in the immediate planning future, but five or seven years out? Should it be higher than what you've achieved in the past, given those new businesses growing at higher margins?

Speaker 3

It's a provocative question, David. There are so many factors that go into determining operating margins, including, of course, our raw material cost. Our general view is that operating margins should continue in the 30+ level and could very well approach the mid-30s over the next few years.

Speaker 0

You've done better than that, beyond that, given the growth with the buy.

Speaker 3

Very boldly, David.

Speaker 0

Very good. Thank you.

Speaker 6

Thank you. Our final question comes from Paul Lejuet with Nomura. Please go ahead.

Speaker 4

Hey, thanks, guys. Just wondering, as you think about the European expansion, how much your store growth will be centered on tourist-type destinations versus stores that are more likely to attract a more local public? Thanks.

Speaker 3

Good question. Initially, a good portion of our business will be focused on tourists because we're opening major locations in major cities where tourism accounts for a majority of business within those markets. As we develop awareness and interest in the brand among locals and expand our fleet to secondary cities as well as suburbs, we will see that mix change.

Speaker 4

Thanks and good luck.

Speaker 6

Thank you for your attention. I'll turn it back to Lew for a few closing words.

Speaker 3

Okay, just a few. I wasn't sure whether my voice was going to last through the call. Of course, we posted an excellent quarter. As you well know, I think all of you are familiar with our track record. We feel very good about where we're positioned for the rest of the spring season and for the fall and do look forward to double-digit top-line and bottom-line growth and would like you along for the journey. Have a good day.

Speaker 6

Thank you, everyone, for your attention. Have a great day.

Speaker 7

Thank you. This does conclude the Tapestry Inc. Earnings Conference call. We thank you for your participation. You may now disconnect.