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Operator
Greetings, and welcome to the American Eagle Outfitters second-quarter 2014 earnings call.
(Operator Instructions)
As a reminder, this conference is being recorded.
I would now like to turn the conference over to your host, Judy Meehan, Vice President of Investor Relations for American Eagle.
Thank you, Ms. Meehan.
You may begin.
- VP of IR
Good morning, everyone.
Joining me today for our prepared remarks are Jay Schottenstein, Interim Chief Executive Officer; Roger Markfield, Chief Creative Director; and Mary Boland, Chief Financial and Administrative Officer.
Also joining us for Q&A today are Simon Nankervis, EVP of Global Stores; Michael Rempell, Chief Operating Officer; and Jen Foyle, EVP and CMO of aerie.
Before we begin today's call, I need to remind you that we will make certain forward-looking statements.
These statements are based upon information that represents the Company's current expectations or beliefs.
The results realized may differ materially from those expectations based on our risk factors, included in our SEC filings.
We've also posted a financial supplement on our website, which Mary will refer to.
Now I'll turn the call over to Jay.
- Interim CEO
Good morning, everyone, and thanks for joining us.
Although the second quarter was clearly not to our satisfaction, the results were slightly ahead of our expectations.
In light of the challenges, the team managed the business well, accomplishing our goal of clearing through Spring and Summer inventories, while delivering a stable merchandise margin.
Second-quarter revenues declined 2%, and EPS of $0.03 was well below last year.
Despite a really tough first half, we remain in solid financial condition, ending the quarter with $263 million in cash, and no long-term debt.
During the quarter, we made good progress on our priorities to strengthen the business.
Now, let me provide a brief update and review of some highlights.
It starts with delivering great merchandise assortments, and an outstanding customer experience.
The upcoming Fall and Holiday product lines are more consistent with what our customers expect from our brands.
The team has done a nice job refining the line, injecting better quality, and adjusting the merchandise presentation.
Gradual improvement should continue as we approach the holiday season, and continue into Spring.
Inventory levels are down from last year.
It's our goal to plan conservatively, and chase where we see demand, while ultimately reducing our reliance on promotions.
As Roger will discuss, we've become more nimble and tightened up our design and production process.
Looking ahead, our priorities also include strengthening customer engagement, customer service, and operational efficiencies.
Over the past year, we have made significant investments in a number of these areas, and are beginning to see the benefits and expect to see returns to the business over the next several years.
First, our new state-of-the-art fulfillment center in Hazelton, Pennsylvania, is up and running, right on schedule.
The facility has added needed capacity to our online business, and supports an omnichannel capability.
We're able to see significantly speed up delivery times, now reaching over 90% of our customers in two days or less.
Next year, we will add store distribution to the facility, and over time, we expect unit processing costs to decline by at least 10%.
Our buy online, ship from store capability is now in 255 stores, wrapping up further by holiday, BOSS is exceeding our expectations, delivering incremental sales.
Over time, we also expect to benefit from lower store markdowns, and see improved inventory utilization.
Next, we've been making ongoing enhancements to our digital site, including the new denim shop, more on body display, and a 360-degree product view.
Additionally, we are about to relaunch our mobile app, enabling a significantly faster and better shopping experience.
We've invested in a national marketing campaign, aimed at strengthening brand awareness, and driving customer engagement, with increased digital marketing.
And lastly, we've begun piloting a new point of sale system that will be rolled out in 2015, providing improved speed integration with our e-commerce business, and upgraded mobile check-out capabilities.
With the completion of a number of these products, next year we see capital spending will come down to roughly $150 million or approximately $230 million this year.
We also remain focused on our expense reduction efforts.
We've done a good job slowing expense growth, but this is not enough, and we continue to go after deeper reductions.
As we rationalize our store fleet, we are evaluating our corporate expense structure.
In fact, across our strategic plan initiatives, we are reevaluating, in some cases, repacing projects, and ensuring we are distributing capital to deliver the highest potential returns.
Our international business performed well in the second quarter.
We continue to see a strong global appetite for our brands.
In November, we will enter the United Kingdom, opening Company-owned and operated stores in three of the most popular shopping destinations in England.
We believe our presence in these centers will provide good returns, and a great foundation for further growth.
Before I turn it over to Roger, let me comment that our CEO search is underway, and we remain committed to finding a strong successor to enhance performance, and capitalize on opportunities.
In the meantime, we have a very strong and talented team in place, and continue to focus on executing our goals.
With that, I'll turn the call over to Roger.
- Chief Creative Director
Thanks, Jay.
Good morning, everyone.
Second-quarter results reflected ongoing headwinds within our sector of retail.
Also, as we indicated earlier, our AE Spring and Summer assortments were not our best, and inventory was planned ahead of demand.
With that said, our performance was slightly better than we expected, and we accomplished our goal of clearing through excess Spring and Summer inventory.
We saw favorability in our product costs, markdowns stabilized, and we delivered a higher merchandise margin in the quarter.
Over the past several months, we've made progress laying the foundation for the future.
Before I comment further, I'd like to make the following points.
First, all the markdowns were still at unsatisfactory levels.
We have reduced our reliance on broad wide promotions.
This is a significant opportunity for margin improvement, as we move forward.
Next, inventories are in good shape, and planned down in the back half.
We are keeping more open to buy, and using our fast track capability to chase demand.
And third, we realigned the design and merchandising teams to ensure we have the right talent in the right jobs, and supported by the right process.
We made critical changes over the past several months, and I'm confident we are now in a much better place.
We've made some progress on the back-to-school floor set, and expect to see improvements ramp up through Holiday, and into the Spring season.
We are telling the lifestyle story better, and our stores reflect the stronger point of view with key categories front and center.
New trends in bottoms played to the strength of the American Eagle brand.
New styles and rises are combined with updated fabrics on our tried and true fits.
We've also introduced great variety and newness with joggers, leggings, soft pants, fleece, and twills.
To address the change with new trends, our denim business was planned down for last year and that's how it's trending; however, we are maintaining a less promotional stance.
Denim is holding up well in a highly competitive landscape, and remains a healthy and profitable business.
While challenges still exist in the macro and competitive landscape, we've seen incremental improvements from the first half, and are somewhat encouraged by early selling, especially in the women's business.
We plan to build on this success throughout the season and into Spring.
Last week we launched our new national marketing campaign, I'MPERFECT, our diverse 360-degree customer outreach across social media, in store, digital, magazines, online video, and TV.
It's critical that we continue to build brand awareness, and strive for greater customer engagement.
While we are confident, we are also realistic about the environment.
Our plans provide greater flexibility to read and react to trends.
Our merchandise planning and sourcing teams have done a great job tightening up production schedules, reducing lead times, and leaving more open to buy.
Now, on the aerie brand.
I must congratulate the teams for delivering a strong quarter.
Aerie achieved positive comps and higher margins in the second quarter.
Across merchandising, marketing and customer engagement, the teams executed extremely well.
We leveraged aerie's most popular bra fits into a successful swim business, and we're driving newness with exciting soft dressing trends.
Bras and undies remained solid as well.
We're pleased to see how aerie customers are responding, as we position the brand in proximity to the AE store, delivering a true shopping destination for our customers.
The new aerie side-by-side store design is exceeding expectations, and driving improved four-wall productivity and profitability.
The runway for aerie is long, and we are very excited about the future opportunity.
Looking ahead, our focus for both AE and aerie is on continuous improvement across all areas.
In addition to merchandising, we're working on customer engagement, customer service, and operational efficiencies.
Investments in infrastructure, technology, and digital, as Jay reviewed, will begin to deliver results, and pave the way for improved performance.
Overall, I'm extremely pleased with the team's performance, working through a challenging and dynamic business environment is never easy.
Yet, I'm proud of how everyone has pulled together, and made quick adjustments to our process and plans.
I'm certain that as we prioritize merchandise improvements and strengthen the customer experience, we will achieve the results we expect, with ongoing improvements domestically, strong acceptance and growth internationally, and the potential for aerie, we are well positioned for bottom-line growth.
Thanks, and now I'll turn the call over to Mary.
- CFO & Chief Administrative Officer
Thanks, Roger.
Good morning, everyone.
Despite ongoing pressure in our sector, our second-quarter performance came slightly ahead of our expectations.
Top line weakness caused the deleveraging of fixed expense.
Compared to last year, markdowns improved as the quarter progressed, reflecting an improvement in our inventory position for the back-to-school season.
Now, looking at the details for the quarter.
Total revenue declined 2% to $711 million, compared to $727 million last year.
Revenue from new store growth, primarily factory and international, nearly offset the negative comps.
Consolidated comparable sales declined 7%, following a 7% decrease last year.
By brand, AE comps were down 8%, and aerie increased 9%.
On a consolidated basis, transactions and the average transaction value declined.
The average unit retail was down in the mid single-digits, largely driven by Spring and Summer clearance.
Additional sales information can be found on page 5 of the presentation.
The gross margin of 33.4% declined 40 basis points.
The comp decline caused buying, occupancy, and warehousing costs to increase 180 basis points, as a rate to revenue.
This was largely offset by favorability in merchandise and design costs, as well as a slight improvement in the markdown rate.
SG&A expense of $190 million increased 2% from last year.
As a rate to revenue, SG&A increased 110 basis points to 26.7%.
Investments in advertising, international growth, new factory stores, and omnichannel initiatives drove the increase, and were partially offset by reductions in overhead and variable expenses.
As Jay mentioned, we continued to work hard on further expense reductions, which we expect to ramp up as we progress through the year.
Depreciation and amortization increased to $35 million, deleveraging 90 basis points, driven by omnichannel and technology investments, new factory and international stores, and the new fulfillment center.
Operating income for the quarter was $12 million compared to $29 million last year, and EPS of $0.03 decreased 70% from EPS of $0.10 last year.
Turning to the balance sheet.
Starting with inventory, which can be found on page 6 of the presentation, we ended the quarter with inventory at cost per foot down 18%, following a 1% decline last year.
The year-over-year decline includes a change in the timing of inventory ownership.
As a reminder, late last year, we began taking ownership at the receiving port, rather than the port of departure, creating working capital efficiencies.
Without this change, inventory cost per foot decreased in the mid single-digits.
We were able to effectively clear through excess Spring and Summer sale merchandise during the quarter, and as a result, we ended the period with clearance units well below last year, and overall inventory levels on plan.
We expect third-quarter ending inventory at cost per foot to decline in the low double-digits with the change in ownership, or a mid single-digit decline, excluding the ownership change.
We ended the second quarter with $263 million in cash and investments.
Capital expenditures totaled $74 million for the quarter, and we continue to expect to spend approximately $230 million this year.
As Jay mentioned, we expect CapEx to drop off to approximately $150 million in 2015.
During the quarter, we opened 20 stores, including 5 new North American main line stores opened in under-penetrated markets, such as Las Vegas and Quebec City.
We opened 10 factory stores, 3 stores in Mexico, and 2 stores in China.
We closed 5 stores, including 3 AE main line and 2 aerie standalone locations.
Additionally, we opened 7 international license stores, ending the quarter with 84 stores across 13 countries.
Additional store information can be found on pages 9 through 11.
Now regarding the outlook for the third quarter.
Based on a slight decline in revenue, and a mid single-digit decline in comparable sales, we expect third-quarter EPS of $0.17 to $0.19.
Our guidance compares to adjusted earnings of $0.19 per diluted share last year, and excludes potential impairment and restructuring charges.
We expect third-quarter markdowns to decline, and SG&A is expected to increase in the mid-single-digits.
It's important to note that this follows a $13 million or 6% SG&A reduction in the third quarter last year, due in part to an incentive adjustment.
Excluding this adjustment, SG&A is expected to increase this year in the low single-digits.
Yet, as Jay said, we are targeting further reductions.
Now I'd like to provide more details on our fleet repositioning.
the majority of our AE store fleet is healthy and generated four-wall profitability on a trailing 12-month basis.
For the American Eagle stores, the average sales productivity of the fleet is over $400 per gross square foot, with double-digit four-wall profitability.
That said, we continue to look at the entire store portfolio, evaluating sales trends to identify potential closures.
Last quarter, we outlined our plans to close 100 AE and 50 aerie stores over the next three years.
These stores underperform the fleet, with average sales productivity of $250 per square foot.
Of the closures, most are in B and C malls, and geographically dispersed throughout North America.
Our investments in factory and aerie side-by-side stores are generating a return.
Factory store productivity is over $600 a foot, and four-wall profitability is over 25%, well above the chain average.
As you know, part of our strategy for aerie has been to close unprofitable standalone stores and reposition the fleet as side-by-side locations, next to our AE stores.
In 2014, we plan to close 27 standalone stores, and open 29 side-by-side locations.
Early results have been very favorable, with new side-by-side locations more profitable and nearly 30% more productive than aerie standalone stores.
Additionally, the majority have also produced a list of comps in the adjacent main line store.
Lastly, we are highly focused on deeper expense reductions, to fuel stronger margins and enable us to fund strategic investments necessary for our long-term success.
Thanks for listening, and now we'll take your questions.
Operator
(Operator Instructions)
Our first question today is coming from Matthew McClintock from Barclays.
- Analyst
This is [Greg Bagley] on for Matt.
Just wondering if you could talk about any early reads from back-to-school.
Seems like most retailers are pretty positive to date.
Just any major category call-outs and any difference in your strategy this year versus last?
And I have one follow-up after that.
- VP of IR
Roger will take that.
- Chief Creative Director
We don't want to give too much color.
It's still only in the early part of back-to-school and certainly on the competitive spirit, I'd like to give not too much information, but we're relatively pleased with the way the business is trending.
It's on our plan, and overall, the women's business really is picking up extremely better than what we would have thought.
- Analyst
Okay, great and then just on international, China, you've been there for about a year now, and you're opening stores, and you alluded to moving into the UK.
Just wondering what gives you confidence with the consumers in those regions, and your strategy, any high-level stuff would be great.
- VP of IR
Simon, that's for you.
- EVP of Global Stores
Greg, I think in relation to greater China, it's probably a little early to talk about the profitability of the market.
We're annualizing the acquisition of that business in October.
We seen some good improvement, and early indications from our digital channel there has been good in helping us refine the assortment.
In relation to general customer demand and the appreciation from the customers, we've had an international business since 2010.
We seen good demand, and we've seen strengthening in our international locations, both the ones that we own ourselves and also the ones that are operated by our licensed partners, so we have early indications, and based on that run rate, we still feel incredibly confident about our ability to execute, and for customer engagement and acceptance of the brand.
Operator
Our next question is coming from Simeon Siegel from Nomura Securities.
- Analyst
So you mentioned opening the main line stores in the underpenetrated markets, and I think you upped your FY14 opening plans, can you speak to that opportunity?
And Mary can you quickly talk to the gross margins implied within the Q2 guidance, given the clean inventories and the fact that you're lapping meaningful erosion in the back half?
- EVP of Global Stores
Simeon, this is Simon.
On the underpenetrated mainline stores, as part of our fleet rationalization we've looked broadly across all of the geographies.
We've identified certain markets as we said in Q1, where the brand still had opportunity because we didn't have sufficient store concentration, nor have we seen an ability to drive significant opportunity through cross shopping at various channels.
A great example is Las Vegas, where we knew that we were underpenetrated so we've identified those locations.
We continue to look for opportunities, but the overriding thing is really to look at getting the North American fleet, in total, back to profitability, and part of that will be the continued focus on the rationalization, which will include remodels, store movements, but predominantly store closures over the next 12 months.
- CFO & Chief Administrative Officer
And then on gross margin for Q2, it deleveraged about 40 basis points.
That was driven by our deleverage of BOW, which was almost offset by some favorability in our markdowns, and our product cost, so fairly close to being flat versus LY.
As I look forward to the back half of the year, not giving specific guidance on gross margin, but I would expect for our gross margin rate to reach up something closer to the 37% to 38% range in the back half of the year.
Operator
Our next question is coming from Susan Anderson from FBR Capital Markets.
- Analyst
I was wondering if you could give us some more color on the product cost efficiency in the second quarter, mainly the merchandise and design savings.
Exactly what was that?
And do you expect this to continue to flow through, through the rest of the year?
And then also was this a bigger impact than the markdown, the better markdowns?
Thanks.
- CFO & Chief Administrative Officer
Yes, for the second quarter, you know the savings was really driven by great work by our sourcing team, just driving for efficiencies.
There wasn't anything specific there, but more kind of across-the-board efficiency work.
For the balance of the year, while the team continues to drive for efficiencies, what it looks like is we're basically flat for the back half of the year, so wouldn't expect to see any average unit cost impact in the back half of the year, one way or another.
Operator
Our next question is coming from Paul Lejuez from Wells Fargo.
- Analyst
Can you talk about the performance at e-comm, and also if you could, by A, B, C, D, and outlet malls, where you saw the strongest performance?
And then just secondly, I know you talked about cutting expenses.
I'm wondering if, as you have had a deeper dive into the business, if there are any areas you feel you've under-spent or under-invested?
Just trying to figure out how to think about SG&A growth longer-term.
Thanks.
- VP of IR
We'll start with Michael Rempell on e-commerce.
- COO
Hi Paul, it's Michael.
About e-commerce, we aren't breaking out e-commerce comps separately, but what I would tell you is, we're pleased in the improvement in the run rate we saw between Q1 and Q2 in e-commerce.
Some of the initiatives that we put in place redesigning the site contributed to a lift in conversion, and we're expecting continuing improvement going forward.
Like I said, we're pleased, we're not completely satisfied, and we recognize there's a lot more opportunity.
So we're focused on mobile expansion, international expansion, and the flexible fulfillment project, or ship from store, that Jay talked about earlier.
- EVP of Global Stores
And Paul in relation to the performance of the various brick and mortar channels, really, we didn't see a dramatic difference between A through D. Pretty much the comps were flat across the chain.
As Mary said earlier, we're sort of seeing sales in that $400 gross per square foot, and factory still managed to maintain average sales around $600 of gross per square foot.
- CFO & Chief Administrative Officer
And then in terms of SG&A growth longer term, as I mentioned, we're looking for SG&A to continue to increase on a consistent basis here in the low single digits.
Having said that, we are aggressively pursuing further cost reductions here in the Company, which you'll start to see some of that impact later this year, into the first of next year.
I think we're trying to balance a lot of things here, the need to continue to invest in advertising behind our brand, to support in the market, and also trying to balance the short-term with the long term.
So we're looking at areas of the business that are attached to the declining part of the business, which is brick and mortar, and trying to continue to rationalize that cost base.
But we still need to invest for the long term here, because that's what this is about.
So trying to balance all of that together, and we'll continue to stay focused on expense reduction, and keep you posted.
Operator
Our next question is coming from Randy Konik from Jefferies.
- Analyst
So I guess in the presentation, it said that the transaction counts were down slightly.
Is there any color, if the transaction counts turned positive in the last month of the quarter?
And then with regards to the merchandise margins, I think you said they were up.
Is that really a function of better planning of inventory, or are you seeing a better sell-through rate on the product?
And then lastly, on the CapEx guidance, you gave CapEx guidance of $150 million for next year.
Is that a number that can come down further in a year after that?
Just kind of trying to think about what is maintenance-type CapEx levels, thanks.
- CFO & Chief Administrative Officer
Okay, the CapEx, historically the Company has spent around $100 million to $200 million, depending on the year.
We're planning, as we said, at about $150 million.
I think as we look at our business and our growth potential, we'll need to continue to invest outside the US.
I think $150 million is probably at this point in time about the best planning number to use going forward.
Your question on merch margin.
The merch dollars were pretty flat here for Q2, but we did improve the rate here pretty significantly.
There are lots of things that drove that, and as I look forward at our merch margin, we've got product improvements that the team has been working on, we are focused on marketing.
We do continue to focus on inventory, and that's a big component of this, and to help drive down our markdown rate, and we'll see that markdown rate continue to decline, as the year goes on so it's not really any one single item, it's a combination of a lot of effort across the Company.
Operator
Our next question today is coming from Steph Wissink from Piper Jaffrey.
- Analyst
Just a real quick clarification, in respect to Paul's earlier question on the expense reduction.
Mary, could you give us a sense on the balance between headquarters-level expenses and what you expect to be looking for at the store level, in terms of drawbacks?
And then Roger, if I could put one in front of you as well, on the aerie business, could you talk about the mix of that business relative to what its been historically between intimates, lounge and maybe even into the activewear category?
Thank you.
- CFO & Chief Administrative Officer
Regarding the expense reduction, what's most important here for us is that we maintain our great customer experience, that's critical to our brand.
So we're always very careful about how we look at expense reduction in our stores.
Having said that, there's efficiencies to be found everywhere, including our stores, so Simon and team continue to focus on that, and drive efficiencies.
I would say a lot of the focus here, though, does need to be on the overhead side, the corporate overhead side.
As the Company's revenue has been relatively flat, we need to continue to drive for actual reductions there, and that's what we're working on.
- Chief Creative Director
Stephanie, I'm fortunate to have Jennifer Foyle here with me, who's leading that aerie, great business, so I'll let her give you her comments.
- EVP & CMO of aerie
Stephanie how are you?
We're excited about the focus on the intimate apparel portion of the business in aerie.
We've penetrated that business, and we're winning because of really investing in bras and undies.
That penetration is about 65% of the total, and the balance resides in near-in categories such as swim and lounge, which is really the balance of the assortment.
- Analyst
Thank you.
Operator
Our next question today is coming from Thomas Filandro from SIG.
- Analyst
I'd like to offer some congratulations on a well-managed quarter in a tough environment.
Roger, can you please discuss maybe some of your forward merchandising views of the business for Fall and holiday?
Where do you see the greatest opportunities?
In terms of the current season as well as holiday, can you tell us if there have been any changes in SKU count and how you're viewing AUR?
And just quickly, kudos to Jen and the team for the Aerie performance.
Can you remind us of the size and profit profile of that business?
Thank you very much.
- Chief Creative Director
Tom, thanks for your note.
At the same time I don't really expect that you expect that I will give much detail on what you ask for, but I will tell you that I definitely expect the average unit retail to continue to increase.
- VP of IR
aerie profit profile?
- CFO & Chief Administrative Officer
Yes, so the Aerie overall profitability is accretive to our bottom line, and as the team has gone through and assorted or changed the assortment here over time, and as we're moving out of the standalone to the side-by-sides we're seeing further improvement in profitability, and a great improvement in overall productivity, so continue to see great improvement in the Aerie profitability, and we expect that trend to continue.
Operator
Our next question today is coming from Adrienne Tennant from Janney Capital Markets.
- Analyst
Let me add the nice progress on the inventory management.
Roger, I wanted to talk to you about -- you'd made some comments about lowering your inventory or down inventory investment in the denim category.
What percentage of that is back-to-school Fall sales?
And earlier in the year, you had changed to investing more in commodities or I should say, basic fashion basics, and I'm just wondering if you can talk about that mix shift for the Fall season as well?
Thank you.
- Chief Creative Director
I think I can give you a little color without giving you percentages.
- Analyst
Okay.
- Chief Creative Director
Certainly, we have a very healthy and profitable denim business, and as you know, our market share is well over 30% in the space, which is quite frankly, a huge market share.
I believe we're maintaining that level of market share, and probably growing it, and I think our denim assortment is quite significantly better than its ever been before.
As it relates to fashion mix, we have core, we have core fashion, and then we have fashion.
And the way we have the mix now with tighter inventories, and the way we're chasing, especially on the women's top business, is really working nicely for us.
- Analyst
Great, thank you very much.
Operator
Our next question today is coming from Brian Tunick from JPMorgan.
- Analyst
Hoping to get maybe a couple of quick liners on the factory comp declines in the quarter, and also your view on the men's business, that's been decelerating?
And then just maybe any comments on the port strike and any impact that could have on product flows or ship versus boat costs?
Thanks very much.
- EVP of Global Stores
So I'll talk to you Brian quickly about the factory comp declines.
What we saw is, last year if you recall, we opened a lot of factory stores, and what we think we've seen in Q2 is the hangover from those initial openings, and the enthusiasm of a number of new malls opening, plus the rapid expansion that we had into that.
And what we're seeing now is a settling down of the run rate into more normalized levels of the chain, historically.
- Chief Creative Director
On the men's business, you recognize that men's is a bit more of a commodity-driven business than the women's business, which is more a fashion-oriented and the price pressure in the malls is quite dramatic, and we choose not to meet those prices.
Our quality of our product, I believe, is that much better.
3 But for holiday, it is significantly better, and I think we'll start to see a change in trend, as we move mens into holiday.
- VP of IR
The strike, Michael?
- COO
On the port strike, it's obviously something that we're watching very carefully.
The team does have contingencies in place, should a strike occur.
As of now, it's a wait and see game, and hopefully we'll get through holiday without an impact.
Operator
Our next question today is coming from Anna Andreeva from Oppenheimer.
- Analyst
Great, thanks so much for taking my question.
Great to hear about improvements in the business for back-to-school.
I guess a question, are you running in line with negative mid single digit comp guidance, or do we need a business to accelerate to get there?
And maybe remind us of how your comparisons shook out in September and October versus August?
And a question to Mary.
With CapEx levels coming down next year, just maybe remind us how much cash cushion you need on the balance sheet?
And any updated thoughts on the share buybacks, thanks.
- VP of IR
A lot of questions.
Mary?
- CFO & Chief Administrative Officer
Yes.
So our guidance on comps was down mid-single digits, that's how we think the third quarter will play out.
We are not looking for any huge trend over the coming months.
We don't give monthly comp guidance, so I'll just leave it there at the quarter.
In terms of the cash cushion, we've always said on a annual basis, we need somewhere around $200 million to $250 million of cushion to make sure we have enough cash to weather anything that comes our way, and we're in great shape here, ending the quarter at $263 million of cash, and feel good about that.
In terms of share buybacks and shareholder return, again, our focus continues to be investing in our business and investing for long term growth.
We provide shareholder return through an outstanding dividend, and we continue to evaluate the possibility of share buybacks.
Operator
Our next question today is coming from Richard Jaffe from Stifel Nicolaus.
- Analyst
Just a working model question, and then a follow-up to the margin question.
First, the tax rate for the second half, where do you think that will end up?
And then a bigger question, gross margins of 37% to 38% in the second half will be really terrific, and wondering if that's as much a factor of much leaner inventories and a much more disciplined approach to markdowns, as it is to full price selling?
So wondering how you're seeing one factor versus the other impact the numbers, and what you're basing the margin outlook on?
- CFO & Chief Administrative Officer
Yes, so the tax rate for the year, we're expected to kind of settle in here at about 44%, somewhere in that ballpark, so obviously we'll come down here in Q3 and Q4, from where we've been pacing the first half of the year.
As I look at gross margin in the back half of the year, it is really about more effectively managing our inventory and investing the inventory, chasing inventory on product lines that are really working, versus getting out of balance with the total trend.
Leaner inventories mean less markdowns, and as we said earlier, we saw our markdown rate start to improve as we've gone away from as many box out promotions versus last year, and we expect to see that continue.
We're seeing that in August as well.
So I feel pretty good about the combination of product, the combination of focused marketing, the continued focus on inventory here.
All of that should result in a lower markdown rate, and help drive our gross margin up.
Operator
Our next question is coming from Jennifer Davis from Buckingham Research Group.
- Analyst
Let me add my congratulations on good performance, in a really tough environment.
I had a quick clarification, and then, I wanted to see Mary, if you could discuss AUCs for maybe the first half of next year, especially with cotton down at about $0.64.
But, clarification.
How much of the merchandise margin rate was driven by better cost versus lower markdowns?
I'm just trying to reconcile the decline in AUR because of more Spring and Summer clearance with the merchandise margin improvement, or was it just more Spring and Summer sales in general in the second quarter versus Fall sales?
- CFO & Chief Administrative Officer
Yes, I think I'll just handle the merch margin question, and Michael will talk about average unit costs.
So when you look at Q2, we did see some favorability here in our costing, our product costing which did help our merch margin.
Our markdowns improved about, looks like about 40 basis points in Q2 versus LY, so a fair amount -- that was part of the improvement, but more of it was driven by the product cost side of that.
As we move forward, though, what I would say is that the merch margin improvement will flip around, and be mostly driven by markdown improvement.
- COO
It's really too early to give a forward view of what product costs are going to be for spring and summer, as we're trying to work closer to those seasons.
But what I will tell you is we are carefully watching cotton prices.
If they stay where they are or go down further, we have a lot of cotton in our product, and I would expect we would see some benefit flow through to product costing.
Operator
Our next question today is coming from Dorothy Lakner from Topeka Capital Markets.
- Analyst
Let me add my congratulations on managing through a really tough period, and making really good progress here.
I had a question for Roger.
Just, if you could give us a little bit more color on where you are in terms of how much open to buy you're keeping, and how much of the assortment you're able to fast track at this point?
Thanks.
- Chief Creative Director
Dorothy, we have the process really tightened up.
The way we used to run the business, and we are keeping the right amount of inventory open to chase.
We're now chasing -- we set our next set on 9/11 which is the Fall set, and there is probably about 20% of that inventory was chased.
We're working on holiday.
We have an extraction that will take place in our stores at the end of this month on holiday, and after we read that extraction, we'll go into chase mode for holiday.
- Analyst
The fast tracking?
- Chief Creative Director
That is fast tracking.
Operator
Our next question is coming from Oliver Chen from Citigroup.
- Analyst
Great job on that tough environment.
Regarding your product planning, and what you're seeing for the bottoms trends and the softer dressing and the jeggings and leggings, how does that dynamic work with the lower average unit retail versus denim?
And will the transactions there be able to offset a potential AUR mix headwinds?
And then, Mary, thanks for the details on the gross margin side.
So looking forward, are there certain classifications you're more enthusiastic about, in terms of merch margin expansion opportunities?
- Chief Creative Director
So on the average unit retail question, obviously we follow trend of product and we let the average unit retail come out where it comes out in the mix.
But with the reduction of markdowns and the sell-throughs that we're getting in the women's product, I still believe the average unit retail will be rising, but it's very good for us, with all of these bottom trends taking place, other than denim, we're very well-positioned for that trend.
- CFO & Chief Administrative Officer
And then I think in terms of the gross margin, looking forward at our product portfolio here for the back half of the year, and seeing the improvements in product that Roger and Jen and the entire team are driving, encouraged by what we're seeing.
But I think, honestly, as we sit here today, how I think about planning forward is just keeping inventories in line, making sure we're chasing only what we need to chase, and being able to drive a markdown improvement, by not having to go big box promotional.
So I think the product will speak for itself once it's out, and we'll see what kind of results it delivers.
Operator
Our next question today is coming from John Morris from BMO Capital Markets.
- Analyst
Really nice progress to the entire team.
Mary, a question for you.
Roger had very good comments, constructive comments about the start of back-to-school and we're pleased with where they are, and the women's trending better yet.
You were planning negative mid single digit comp for Q3, although we're up against an easier compare on the same inventory lean levels, so I'm wondering if there's any consideration there for, I guess, the cautious guidance.
- CFO & Chief Administrative Officer
I think that I wouldn't call it cautious guidance.
It's our guidance, and when we look at all of the variables we have here playing for Q3, we feel confident in that guidance, and based on what we're seeing as an early read.
Again, we're really trying to move ourselves away from the big box, off of the promotions that we ran last year.
We started that journey here in the second quarter, and into that journey as we speak.
So expect to see the bottom line results improve as we continue on in the quarter.
Operator
Our next question today is coming from Janet Kloppenburg from JJK Research.
(Operator Instructions)
Our next question today is coming from Jennifer Black from Jennifer Black & Associates.
- Analyst
Congrats.
Your side by sides look amazing.
I wondered if you could talk a little bit about your rewards program, and what type of changes we could expect to see in the back half of the year?
And I wondered how many active members you have?
That's my question.
- VP of IR
Roger?
- Chief Creative Director
We're sitting right now with close to 13 million reward customers, loyalty customers and that's up double digits, so I really feel good when I see that, with the strength of the brand.
And we're in the midst of reworking the whole loyalty program, even though it's successful, so when we complete our analysis on what we're going to do, I'll let you know.
- Analyst
Okay, do you have any comments about your marketing for the back half, for holiday season?
- Chief Creative Director
We're in conversation right now and Mary and Jay and myself and the team, we all believe in marketing the brand.
It's a very powerful brand.
We like where we are with the campaign that we have in place now, My Imperfections, which is resonating, and we'll continue to do something for the holiday season.
Operator
Our next question today is coming from Janet Kloppenburg from JJK Research.
- Analyst
Congratulations on the progress.
Just a couple of quick questions.
Roger, you talked about the down-trending denim cycle.
I wondered if you thought that would continue into the Spring?
And secondly, I wondered if your investments in the alternative bottoms was appropriate now, or if that will be building.
It looks a little light to me in the stores.
I don't know if I have the direct channel.
And Mary, I know you didn't want to talk about current comp trends, but I was wondering if your encouragement on the business for the back half might be related to business trends improving slightly as the back-to-school product arrived in mid July.
Thank you.
- Chief Creative Director
Well I never have a crystal ball, but my sense is that the denim cycle will continue to be a bit soft.
It's still, as I said before, a dominant business, very healthy and very profitable.
The other categories, the leggings business, the jegging business, the soft dressing businesses will continue, and obviously into Spring, and we're obviously in chase mode, and that -- you'll see that in our next set, in our next set of windows.
So I feel pretty good about where we're moving to and how we are positioned.
- CFO & Chief Administrative Officer
And regarding the comp trend, as the Q3 guidance is down mid single digits, as we look to Q4, would expect to see some improvement versus LY.
We had a really tough Q4 last year, so expecting to see some improvement versus LY.
Operator
Our next question today is coming from Betty Chen from Mizuho Securities.
- Analyst
My congratulations as well.
I was wondering, Mary, if you can clarify in terms of the inventory at the end of Q3, total costs moving down, how should we think about unit changes year over year?
And then also in terms of the comp lift you're seeing in adjacent American Eagle stores next to the aerie side-by-sides, what sort of comp lift are you seeing?
And lastly for Roger, are you also seeing some success with the tops business, as you see the better sell-through in the bottoms?
And how are you feeling about some of the new fashion trends, if any, as we go from holiday into the Spring season?
Thanks.
- CFO & Chief Administrative Officer
In terms of the unit inventory, we're down in Q2, looks like about 13% roughly, and would expect to see something similar to that in Q3 versus LY.
Regarding the comp lift between the AE box with Aerie side by side, look, it's early to declare a number, or declare a success.
I would say early read, we're seeing a bet, and we'll just keep you posted, as we get more experience under our belt.
- Chief Creative Director
And the women's top business is strong, and we're in real speed sourcing chase at this point in time.
The swings from where we were in first and second quarter to where we are in the third quarter is quite dramatic.
- VP of IR
Kevin, we'll take one more question.
Operator
Our next question is coming from Jeff Van Sinderen from B. Riley.
- Analyst
Thanks, just to clarify, Mary, I think you said improvement versus last year for Q4.
Just wanted to clarify on that, you mean positive comps; correct?
- CFO & Chief Administrative Officer
No, no, we aren't giving guidance here for Q4.
I think what I was trying to articulate is that we expect to see improvement, a bit of an improvement in our trend based on the strength of all of the work the team has done here, on the product.
- Analyst
And then any update you can give us on the longer term outlook for real estate?
Are you leaning more toward closing more than 100 stores?
I think you've talked about for the next few years, or would you be leaning toward just keeping it at that at this point?
- EVP of Global Stores
So look, Jeff, it's Simon.
Where we're at the moment is, we've got 150 stores, including aerie, that we have identified for closure.
We've got another 200 stores that have leases expiring over the next three years.
As we are moving through the business, and as we are seeing customers' traffic patterns change between the digital channel and the brick and mortar channel, we'll change our focus and update the strategy accordingly.
Operator
Thank you.
That does conclude today's teleconference.
You may disconnect your lines at this time, and have a wonderful day.
We thank you for your participation today.