American Eagle Outfitters Inc (AEO) 2014 Q3 法說會逐字稿

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  • Operator

  • Greetings and welcome to the American Eagle Outfitters third quarter 2014 earnings conference call.

  • At this time, all participants are in a listen-only mode.

  • A question-and-answer session will follow the formal presentation.

  • (Operator Instructions).

  • As a reminder, this conference is being recorded.

  • I would now like to turn the conference over to Ms. Judy Meehan, Vice President of Investor Relations.

  • Thank you.

  • You may begin.

  • - VP of IR

  • Good afternoon, 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 Chief Merchandising Officer 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 actually realized may differ materially based on risk factors included in our SEC filings.

  • Our comments today include non-GAAP adjustments.

  • Please refer to the tables attached to the press release.

  • We have also posted a financial supplement on our website.

  • Now I would like to turn the call over to Jay.

  • - Interim CEO

  • Thank you.

  • Good afternoon.

  • In what continues to be a tough retail environment, we delivered higher margins and earning growth compared to last year, ahead of our expectations.

  • Our results reflect the progress on the work that began earlier this year, to strengthen our assortment and drive better efficiencies across the business.

  • In the third quarter we achieved 16% adjusted earnings growth.

  • By managing the business better, we're able to reduce markdown rates and control expenses.

  • We ended the quarter in good financial condition with a cash balance of $280 million, and no long-term debt.

  • The period overall marked a step forward, yet we have significant opportunity to further strengthen our business.

  • To that end, during the quarter we took restructuring charges aimed at improving the store portfolio and increasing efficiencies at our corporate office.

  • We will continue to close less productive brick and mortar stores as our leases expire, while selectively pursuing new openings.

  • We are reducing corporate overhead expense to eliminate redundancies at the home office and we are in the process of consolidating office space.

  • The work will continue and is aimed at making us more profitable, more efficient and will enable us to invest in areas that will fuel future business.

  • As I said at the beginning of this year, we need to bring fun and innovation back to our Company.

  • I think we made good headway on this front.

  • Our marketing advance and lease lines are more compelling.

  • Our stores, both AE and Aerie reflect higher energy, stronger outfitting ideas, and improved color palette and overall better merchandising.

  • This is an ongoing effort as we strive to continuously stay connected to our customers and build a better brand experience.

  • We have a solid foundation on which to build.

  • Our brands are well positioned in today's marketplace.

  • We will stay true to the AE heritage lifestyle while continuing to increase our speed to market and improve the customer shopping experience across stores and digital channels.

  • Aerie has been a standout performer.

  • They've achieved positive comps and stronger profitability which has continued into the holiday season.

  • We have a highly capable team led by Jen Foyle.

  • Now we need to keep the momentum going as we evolve the assortments and further expand the Aerie brand.

  • On the technology front, we continue to drive advancement in omni-channel.

  • Approximately 15% of digital sales were fulfilled through our ship from store capability which is now in about 530 stores.

  • We've seen faster merchandise shipping times and better inventory utilization.

  • [BOSS] will expand to all stores next year.

  • We also look forward to launching reserve online, pick up in store, providing additional shopping alternatives for our customers.

  • We're also seeing benefits from our new distribution center, which is cutting our average delivery time in half.

  • We continued our global expansion strategy.

  • In November we opened three new stores in London to an encouraging customer response.

  • We will selectively pursue new growth opportunities while staying focused on strengthening our brand domestically.

  • I'm pleased with how the teams are executing our vision and managing the day-to-day business overall.

  • We've done a good job anticipating operational challenges.

  • For example, we successfully managed through the west coast port slowdown with no major disruption to our holiday flow or cost increases.

  • Although we made progress this year, we continue to face weak traffic in a highly promotional sector.

  • In addition, as we cycle against our own history of heavy promotions, it's been difficult to achieve consistent sale performance.

  • Our strategy has been to maintain price integrity by reducing promotional activity.

  • We strongly believe this is the right approach.

  • We've seen some success, yet have plenty of room for improvement.

  • It goes without saying that this is made possible only with great merchandise, the right balance of quality and value, strong inventory controls and engaging customer experience; all major priorities as we move forward.

  • We must continue to challenge ourselves on all fronts.

  • At the same time, we need to continue to bring operating expenses down, deliver stronger profitability.

  • Thanks and now I'll turn the call over to Roger.

  • - Chief Creative Director

  • Thanks, Jay.

  • Good afternoon to all.

  • This season marks good progress, though we continue to face significant headwinds.

  • As Jay said, we've been focused on improving the customer experience and elevating our merchandise assortments.

  • For today's consumer, we are executing an updated lifestyle brand experience that is true to the heritage of American Eagle Outfitters.

  • To be clear, this is finding the right balance between new fashion and updated key heritage looks.

  • We are uniquely positioned as the casual, youthfully optimistic, American inspired lifestyle brand, which ranks high among our customer base.

  • The emphasis we placed on being true to our brand DNA is a very important distinction from how we have operated in the recent past.

  • And in my view, it's the change that when executed well, will successfully lead us into the future.

  • Now let me take a step back and review the third quarter.

  • Although sales declined slightly in a really tough retail environment, we saw improvement from the first half.

  • As we said on the second quarter conference call, lowering promotional activity was a major priority.

  • We delivered on this priority and saw our merchandise margins rise over 300 basis points.

  • This was driven by better merchandise, stronger inventory controls and more strategic marketing events.

  • Consistent with our strategy, we did not anniversary 20 days of 40% off the box promotions hold last year.

  • While mall traffic continued to be a challenge, our more disciplined pricing strategies helped spur an increase in the average transaction value, driven by a higher average unit retail price and strong units per transaction.

  • To underscore what Jay said, our greatest opportunity is to curb promotional activity while delivering sales improvements.

  • On the last call we also talked about supply chain efficiencies; fast tracking and planning our inventories conservatively.

  • This was achieved with quarter ending inventories in good shape and below last year.

  • We continued to drive inventory productivity and improved inventory turn from last year.

  • During the quarter, we chased into strong sellers much more effectively including sweaters, joggers and denim.

  • We made a strategic decision to improve product quality through the use of better fabrics and incorporating new washes and treatments.

  • Essentially, we've added more of the special details we were missing in recent seasons.

  • Our recent launch of AEO Denim X is a great example of innovation in a key heritage category.

  • The response has been very positive and is an example of how we need to deliver newness across the business.

  • We've seen strength in women's sweaters and men's and women's bottoms.

  • Some of the more challenging categories include men's and women's t-shirts and fleece.

  • As a category overall, denim held up extremely well, exceeding our plans and delivering higher margins.

  • Newness in non-denim bottoms such as joggers and jeggings and leggings achieved strong double-digit comps and mostly offset the slight declines we experienced in denim.

  • We continue to work on broadening our offerings, putting more emphasis on accessories, greater gift giving and unique opportunities like American Beagle Outfitters, an example of fun and innovation.

  • Aerie has continued to deliver strong results with positive comp sales and a significant increase in profitability.

  • I'm extremely pleased with the direction of Aerie.

  • Strong performance has continued in the bra and undies business and the team has done a nice job expanding categories, strengthening assortments and leveraging our AE customers.

  • This holiday season the stores look great with an emphasis on gifting, strong colors and exciting new trends in soft dressing.

  • I congratulate the team and look forward to continued success and further expansion of the business.

  • Although we've made good progress against our priorities, our margin rates are still well below our goals.

  • As we continue to strengthen the assortments and drive innovation across product, marketing and customer engagement, we expect to see continuous improvement.

  • I'd like to thank the teams for their hard work, wish you all a happy holiday and now I turn the call over to Mary.

  • - CFO & Administrative Officer

  • Thanks, Roger.

  • Good afternoon, everyone.

  • Despite ongoing macro pressures and weak mall traffic, our third quarter performance exceeded our expectations.

  • While sales were essentially as expected, we effectively reduced markdowns and controlled expenses compared to last year.

  • This led to adjusted year-over-year earnings growth of 16%.

  • Now, looking at the details of the quarter, total revenue declined slightly to $854 million from $857 million last year.

  • Consolidated comparable sales declined 5%.

  • By brand, AE comps were down 6%, and Aerie increased 3%.

  • On a consolidated basis, the number of transactions decreased due to declines in traffic.

  • However, as a result of reduced markdowns and a change in promotional strategies, the average transaction value increased in the high single digits, driven by mid single digit increases in both the average unit retail and units per transaction.

  • Additional sales information can be found on page 8 of the presentation.

  • Total gross profit increased $17 million and as a rate to revenue rose 200 basis points to 36.9%.

  • The margin improvement was driven by reduced markdowns and was partially offset by 120 basis points of buying, occupancy and warehousing deleverage.

  • SG&A expense of $205 million declined 1% from $206 million last year.

  • As a rate to revenue, SG&A held flat to last year at 24% despite negative comps.

  • We were pleased with good expense management driven by reduced overhead and variable expense, partially offset by continued investments in new stores and international expansion as well as increased incentive expense accruals.

  • Depreciation and amortization increased to $37 million, deleveraging 40 basis points due to omni-channel and IT investments, new factory and international stores and the new fulfillment center.

  • On a non-GAAP basis, our tax rate was 42.4% in the quarter, reflecting reserves against international startup.

  • Adjusted operating income grew 22% to $74 million and the operating margin expanded 160 basis points to 8.7% as a rate to revenue.

  • Adjusted EPS of $0.22 increased 16% from an adjusted EPS of $0.19 last year.

  • Now turning to the balance sheet.

  • Starting with inventory, which can be found on page 9 of the presentation, we ended the quarter with inventory at cost per foot down 14%.

  • 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 at cost per foot decreased 3%.

  • We expect fourth quarter ending inventory at cost per foot to be up slightly following a mid-teen decline last year.

  • Fourth quarter ending inventories reflect an acceleration of spring receipts due to the west coast port slowdown.

  • Fall and holiday end of season inventories are expected to be down approximately low double digits.

  • We ended the second quarter with $280 million in cash and investments.

  • On December 2, we closed on a new $400 million asset-based credit facility, replacing the existing $150 million revolver.

  • The new credit facility, which carries a five year term, remains undrawn and provides increased financial flexibility, liquidity and takes advantage of a favorable credit environment.

  • Capital expenditures totaled $64 million for the quarter.

  • We continue to expect CapEx to be approximately $230 million this year, falling to $150 million in 2015.

  • During the quarter we opened 23 stores including five North American mainline stores, 10 factory stores, 5 stores in Mexico and 3 in Asia.

  • We closed three stores including two Aerie standalone locations.

  • Additionally, we opened 10 international licensed stores, ending the quarter with 94 licensed stores across 14 countries.

  • We are on track to close over 70 stores by year end, with over 40 closing in January.

  • Additional store information can be found on pages 12 through 14.

  • Now I'd like to review the restructuring charges incurred during the quarter.

  • Third quarter GAAP results included approximately $51 million or $0.17 per share of charges related to our profit improvement initiative.

  • This includes roughly $33 million of non-cash store and asset impairment charges.

  • As a result of our store fleet review and challenging performance this year, 48 AE and 31 Aerie stores were impaired.

  • Third quarter GAAP results also include $18 million in restructuring charges related to corporate overhead reductions, including severance and related items and office space consolidation.

  • Regarding the outlook for the fourth quarter, we continue to operate in a volatile and highly competitive environment.

  • As we see it currently, we expect a slight decline in revenue and a mid single digit decline in comparable sales.

  • For the fourth quarter, we are expecting EPS to increase over last year to $0.30 to $0.33.

  • Our guidance compares to adjusted earnings of $0.27 per diluted share last year and excludes potential impairment and restructuring charges.

  • We expect fourth quarter markdowns to decline.

  • As we anniversary a $37 million or 15% decline in SG&A last year, due to incentive reversals and lower advertising expense, we currently expect operating expense to increase in the high single digits in the fourth quarter.

  • In addition to the impact of incentives, the balance of the increase is due to advertising and new store openings.

  • Now looking forward to 2015, the results of the restructuring will drive gross savings of approximately $27 million across gross margin, SG&A, and D&A.

  • These reductions will be largely offset by inflationary costs and strategic investments including omni-channel projects, customer-facing activities and continued global expansion.

  • As a result, SG&A dollars are currently expected to be in the range of flat to down slightly in 2015.

  • We continue to strive towards gross margin in the high 30s, which we expect to come primarily from continued reductions in markdowns.

  • [BOW] is expected to increase in the low single digits in 2015.

  • Our plans to close 150 stores over the next three years remain on track and we continue to assess the fleet for additional closures.

  • In 2015, we will open about 20 to 25 stores, primarily factory and international locations.

  • We will close approximately 70 stores including 20 Aerie standalone stores and most of the closures will occur upon lease expiration in January of 2016.

  • While new stores continue to deliver higher returns and have higher sales per foot than the stores we are closing, the new stores also carry higher rents, leading to the increase in BOW.

  • We remain committed to executing on our priorities to reduce promotional activity, improve assortments and control inventory while continuing to bring down expenses to strengthen our profitability.

  • Thanks for listening and now we'll take your questions.

  • Operator

  • Thank you.

  • We will now be conducting a question-and-answer session.

  • (Operator Instructions).

  • The first question is from Simeon Siegel of Nomura Securities.

  • Please go ahead.

  • - Analyst

  • Thanks.

  • Good afternoon, guys.

  • Can you talk about your view to the long-term store targets, between full price, factory, domestic and international.

  • Mary, there are clearly markdown factors that could skew this, but historically it looks like the Q4 gross margin rate has been below the Q3 gross margin rate on a seasonal basis.

  • Any reason that shouldn't be the case this quarter and embedded in there, what are you expecting within your guidance for Q4 gross margins?

  • Thanks.

  • - EVP of Global Stores

  • Hi, Simeon.

  • It's Simon.

  • I'll take the first part of the question and pass it off to Mary for the second part.

  • So in relation to the blended mix between factory and mainline, it's part of our continuing strategy to assess where the mainline fleet looks in the US in particular.

  • As we've said on earlier earnings calls, we look at the way that our customer's currently shopping between the various channels and we use that as a leading indicator to tell us how many stores we should have in each of the various channels and where there's been movement between our shopper in the factory and mainline channel.

  • And then overlaying that is the digital strategy we have through our flexible fulfillment opportunities with buy online, ship from store and the other opportunities that we're working towards for 2015.

  • In relation to international, we've really just commenced that journey from an owned and operated perspective.

  • We continue to develop the licensed business relatively aggressively at the moment.

  • It's a low capital investment initiative for us with a high return on investment.

  • And from an owned and operated perspective, we're going to evaluate the way that those stores continue to perform and as the stores perform and we see the return on that investment we'll continue to expand accordingly.

  • - CFO & Administrative Officer

  • Regarding gross margin for the fourth quarter, expecting it to be probably in the mid-30% range, which is slightly down from Q3 but pretty consistent with Q1 and Q2.

  • I think more importantly that gross margin in the mid-30s will be a significant improvement over last year.

  • Could be pretty close to 300 basis point improvement.

  • So seeing that good trend continue into Q4.

  • - Analyst

  • Perfect.

  • Thanks a lot.

  • Good luck for the holidays.

  • Operator

  • Next question is from Matt McClintock of Barclays.

  • Please go ahead.

  • - Analyst

  • Hi.

  • Yes.

  • Good afternoon, everyone.

  • Really impressive job of reducing the box-wide promotions this quarter.

  • Now that we're into the holiday season, I was wondering if we could get your updated thoughts on given the environment itself, are you more or less optimistic that the promotional intensity or your -- and the strategy to be able to reduce those box-wide promotions given where the promotional intensity is of the industry?

  • And then also a second question; I was wondering if you could update us on the franchise stores internationally, haven't heard much on the performance of those.

  • You're opening a good number of those this quarter.

  • Maybe update us on where those stores stand relative to the performance of the last time you updated us on that.

  • Thanks.

  • - Chief Creative Director

  • Pricing strategy obviously is contingent on having a stronger, better compelling product than the marketplace and that which we had last year.

  • So with that ability, if we believe we have it, we have a strategy in place and we want to be consistent with that.

  • So at this point in time, yes, the promotional activity in the malls is greater than ever.

  • It's deeper than ever.

  • So at this point we're staying pretty consistent to our vision.

  • - EVP of Global Stores

  • Mark, in relation to the franchise business, we opened two additional markets in Q4, being Thailand and Indonesia.

  • We've seen continued expansion with our existing licensees.

  • We've been really happy with the performance of those businesses and I think the growth that you've seen in the store counts is reflective of the way that those markets have performed.

  • In relation to the earnings that we've seen coming out of that, we've been really positive.

  • We've seen positive improvement in that and we're continuing to see additional opportunities with new partners coming on into next year.

  • Operator

  • Thank you.

  • The next question is from Thomas Filandro of Susquehanna.

  • Please go ahead.

  • - Analyst

  • Hi.

  • Thanks.

  • First, happy holidays to all.

  • Again, my congratulations for delivering solid execution in a tough environment.

  • - CFO & Administrative Officer

  • Thank you.

  • - Analyst

  • Jay, a question for you.

  • It's kind of a broader question.

  • I was curious, can you tell us what gives you confidence in the viability of the business model?

  • Because some have questioned the viability of the business model as well as the brand direction and leadership.

  • And then second part of that or third part of that, long term what do you see the balance between brick and mortar and DTC?

  • Thank you.

  • - Interim CEO

  • You asked he three questions there, Tom.

  • - Analyst

  • I cheated, Jay.

  • Sorry.

  • - Interim CEO

  • You know what gives me confidence?

  • On the new product that we introduced, we see a very good reception on it right away with the customer.

  • So my feeling is that it takes a combination.

  • Number one, we have to get the right product, the right quality and that's where we put our emphasis this past 9, 10 months on, is really getting the product right.

  • And we made a lot of progress.

  • I'd say the last nine months, this quarter on the quality of the product is much improved than it was nine months ago.

  • From that direction, everything's going the right way.

  • The second thing is you're never completed.

  • And I feel that there's still a tremendous opportunity out there to create more excitement within the store.

  • Roger and I and the team we've worked on it and we feel there's a lot of opportunities for the next 12 months coming up and as soon as we get through the holiday season we'll start working on that.

  • So I'm very optimistic on the brand.

  • We see the way the customer responds between on the brick and mortar and also we see the response of our website, the way the customer's responding.

  • It's very positive that we didn't go to the 50 off discounts on our site.

  • We went to 40 off.

  • But yet we got very good results at 40 off.

  • I think we did better at the 40 off than the team was anticipating.

  • So that's positive.

  • I feel that if that in this type of environment, as long as we stay true to our beliefs and stay true to the heritage of the company, I think we'll be in very good shape.

  • We see a lot of -- we see Aerie, Aerie's had good results.

  • They haven't done any steep discounting.

  • We see big opportunity there.

  • The international business is being strong.

  • We see an opportunity coming up very shortly of expanding our e-tail business overseas.

  • So there's lot of real positive things going on.

  • It's just a lot of work to do, but everyone's up to the task.

  • - Chief Creative Director

  • Obviously Jay and I talk every day and we're in sync on all of the things that he just talked about.

  • When people challenge the viability of the lifestyle brand equity, if you take a look at all of the research, not the ones that we've done, but your due diligence throughout the industry has done, American Eagle is by far the strongest brand.

  • Our brand equity score is higher -- other than Nike, we're the second strongest brand in apparel retailing in this demographic.

  • We're a very powerful brand.

  • Our share of market in bottoms is dramatic and our power as a destination store in denim is unequaled.

  • We have so many parts of the lifestyle brand that work for us, that the customer comes to us for as the destination store.

  • And now by putting the right product in, in a complete lifestyle way with the right finishes and washes and details, it is resonating with the customer as you can see our results, vis-a-vis the competition at this point in time, Tom.

  • I feel as optimistic of the positioning of a lifestyle brand versus fast fashion as I've ever been.

  • Operator

  • Thank you.

  • The next question is from Adrienne Tennant of Janney Capital.

  • Please go ahead.

  • - Analyst

  • Good afternoon, everybody.

  • My question's more sort of on a philosophical level.

  • There's a tradeoff as you pull back on the promotions between the gross margin rate and then gross margin dollars.

  • I'm wondering, as you're less promotional than others, some of your competition, are you concerned that in the near term you may lose some share while doing the right thing for the company longer term?

  • And then just any update on the CEO search would be wonderful.

  • Thank you very much.

  • - Chief Creative Director

  • There was two questions.

  • I'll let Jay answer the CEO search.

  • - Interim CEO

  • The process is under way.

  • We're committed to finding a strong successor and as soon as we do, we'll let everybody know.

  • - Chief Creative Director

  • As it relates to share of market in our competitive landscape, obviously we're gaining share of market and I'll leave it at that.

  • Operator

  • Thank you.

  • The next question is from Randy Konik of Jefferies.

  • Please go ahead.

  • - Analyst

  • We saw some of the environment, do you expect to see AURs stabilize at all?

  • Mary, on the CapEx, is there any more further cutting you can do on the CapEx or how should the CapEx look maybe two years out from now?

  • Thanks.

  • - CFO & Administrative Officer

  • If I look at AUR -- I'll answer both questions.

  • As I look at AUR, expect to see a continued improvement in our AUR as we pace through the fourth quarter here and probably a bit into next year.

  • That, again, is really driven by the reduction in markdowns as the product is improved and we backed off the strong promotions.

  • From a capital perspective, as I said earlier, we'll spend about $230 million this year.

  • As I look into 2015 and 2016, we're probably back to what I would call a more normalized rate of something like $150 million.

  • We had a lot of catch-up to do here this last couple of years around infrastructure and some digital spend and that will moderate back to about $150 million.

  • - VP of IR

  • Next question.

  • Operator

  • Thank you.

  • The next question is from Lindsey Drucker Mann of Goldman Sachs.

  • Please go ahead.

  • - Analyst

  • Hi, everyone.

  • I was hoping, number one, can you give us any color on how your performance has been quarter to date and any color on Black Friday?

  • Secondly, Mary, it was great to hear some of those preliminary thoughts on 2015.

  • The high 30s gross margin goal, is that something that you can -- do you have a certain time line to that?

  • I'm guessing you're looking for some gross margin improvement just based on the pace of what we've seen in the back half of this year.

  • And also, any early thoughts on where the tax rate might shake out next year?

  • Thanks.

  • - Chief Creative Director

  • We don't report on monthly information.

  • We report on quarterly.

  • But just to give you a sense, let's say that the month of November is trending pretty similar to how third quarter was doing, which we were quite pleased with.

  • Obviously we were not nearly as promotional as we were last year for the Black Friday weekend and certainly our margins and average unit retails were considerably higher.

  • - CFO & Administrative Officer

  • I think for gross margin, Lindsey, as I look into next year, every quarter's a little bit different depending on our product mix, et cetera and cadence of store openings.

  • I think for the year I feel pretty good about the high 30 rate, that we'll be able to achieve it.

  • May not do it every quarter, but I think we will for the year.

  • Tax rate, expect that to fall back to something historical levels, right around 40% as we get into next year.

  • Operator

  • Thank you.

  • (Operator Instructions).

  • The next question is from Susan Anderson of FBR Capital.

  • Please go ahead.

  • - Analyst

  • Hi, thanks for taking my question.

  • I was wondering if I could get your thoughts on if we look out a year or two from now on the competitive environment.

  • It seems like things aren't letting up.

  • I know a lot of the teen retailers are rationalizing stores, but then we still are getting a lot of the international players coming into the market.

  • So maybe your thoughts on that and how you think about getting comps back positive.

  • - Chief Creative Director

  • On the competitive landscape and of the international players coming into the market, listen, when you're in this business you kind of thrive on great competition.

  • It makes you perform better.

  • At this point, all of those coming in are really fast fashion guys, they're not really in the lifestyle business where we put together what I call a Broadway show 10 times a year.

  • So our fashion is as updated as anyone else's and we do it 10 times a year with a great floor-set.

  • They're all fast fashion players.

  • So my from perspective, I don't see it as an issue for us.

  • The reality is that some of the competition that was in our space, which it seems to be changing their strategies, may no longer be in the business at all.

  • So I think we're in a great position at this point in time.

  • Operator

  • The next question is from Anna Andreeva of Oppenheimer.

  • Please go ahead.

  • - Analyst

  • Great.

  • Thanks.

  • Good afternoon, everyone and congratulations on managing well in tough environment.

  • - CFO & Administrative Officer

  • Thank you.

  • - Analyst

  • I had a question on inventories.

  • What number should we think of ending the fourth quarter, excluding the earlier spring receipts?

  • Also into 2015, I think you guys still have an opportunity for tight management in the spring.

  • And also maybe an update on factory, it's been a couple of quarters of declining comps over there.

  • Remind us about the sales productivity and the profitability of that business.

  • Thanks so much.

  • - CFO & Administrative Officer

  • Okay.

  • I'm not sure I got all the questions right here, but on inventory, if you exclude the early spring receipts, we'll likely be down kind of low double digits, so fall, holiday we think will be cleared out pretty well by the time we get to the end of the quarter.

  • - EVP of Global Stores

  • In relation to the factory business, we're still seeing that business outperform the mainline.

  • It's still a highly profitable business for us.

  • We've continued the expansion of that network of stores as we've seen growth and opportunities.

  • I think part of the impact on comps has been as you grow the footprint and as the number of new factory developments coming on, you're not seeing those significant grand openings that we were seeing historically.

  • So we're still really positive about the space and continuing to focus on development of that strategy.

  • Operator

  • Thank you.

  • The next question is from Paul Lejeuz of Wells Fargo.

  • Please go ahead.

  • - Analyst

  • Can you talk about what you see in the fourth quarter and what the outlook is into the first half of 2015?

  • And also curious about e-com performance versus the stores and if you're seeing any difference in categories, e-com versus bricks and mortar.

  • - COO

  • It's Michael Rempell.

  • I'll take your question.

  • First on product cost, product costs continue to be a focus for us and frankly should be an opportunity heading into the back half of 2015 as we have tailwinds from both currency and cotton.

  • You have to remember that in both the fourth quarter this year and in the first half of next year, we're going to anniversary product that was much less expensive, but our customers clearly didn't feel like it was special or unique enough and really wasn't -- they didn't think it was a great value.

  • So during that time, fourth quarter this year into the first half of next year, we expect product cost to be roughly flat as we look to improve the assortment.

  • Our focus as a team is really in the back half of next year where we see opportunity to continue to improve our quality, differentiate our product, but take some of the tailwinds that we have and reduce cost.

  • And the second part was about performance in DTC in terms of the mix.

  • I would say the selling online is roughly the same as what we see in the stores.

  • Operator

  • Thank you.

  • The next question is from Dana Telsey of Telsey Advisory Group.

  • Please go ahead.

  • - Analyst

  • Hi.

  • Good afternoon everyone.

  • As you think about the marketing, what's working?

  • How do you see the marketing spend moving forward and are there any particular categories we should watch for it on?

  • And also, Aerie versus American Eagle in terms of what you're seeing there to help drive the sales.

  • Thank you.

  • - Interim CEO

  • I'll let Jen talk a little about Aerie since it's such an exciting story and we're lucky to have her with us right now.

  • - EVP and Chief Merchandising Officer of Aerie

  • So Aerie, we had a really nice quarter.

  • I was really proud of the team.

  • They really delivered on all fronts.

  • It's really never about one thing, as Roger always says.

  • We had creative marketing, the lease lines were innovative.

  • The product was great.

  • And we have a solid strategy that we're delivering on, which is opening up the new store formats, closing non-productive stores and then not to forget about the direct to consumer channel, that's been really generating nice traffic.

  • We've been leveraging the AE brand and it's aiding in brand awareness.

  • - Chief Creative Director

  • And Dana, as it relates to marketing for both the Eagle and Aerie, you're a real student of the business.

  • I think you can walk into the malls and look at our seven and a half miles of windows and I think you'll say that the marketing of our stores is quite attractive.

  • And it's compelling and it drives people into our store.

  • At the same time, each time we do a set, we're back to the structure and the precision of doing marketing for each one of those sets.

  • It's telling a whole new story.

  • That is something that fast fashion players don't do.

  • That's a very important part of being a true lifestyle brand.

  • When you put together what we're doing on the outside and using our own mobile and web devices to do that, and it corresponds to what we're doing in our stores and in our windows, the combination of all the efforts being very focused drives the message that we need to do.

  • Operator

  • Thank you.

  • The next question is from Rick Patel of Stephens.

  • Please go ahead.

  • - Analyst

  • Good afternoon, everyone and congrats on the progress you're making.

  • I had a question on fashion products.

  • They seem to be doing pretty well.

  • Given what you're seeing, should we expect that assortment to represent a bigger piece of the pie, either for the spring season for back-to-school?

  • And if there are changes that are going to occur, what are the implications for margins?

  • - Chief Creative Director

  • Our fashion business is doing very well.

  • We have great opportunity because as you know, we're such a dominant bottoms business.

  • I won't give you our ratio, but the opportunity and the ratio for us to drive a lot more tops business with the bottoms business, now that we've hit the right fabrications and the right styling and the testing that we're doing is back in place, I see big opportunity as we move into the spring on the tops business and most of that is the fashion.

  • Operator

  • Thank you.

  • The next question is from John Morris of BMO Capital Markets.

  • Please go ahead.

  • - Analyst

  • Thanks.

  • My congratulations to everybody as well.

  • You talked about the customer interfacing initiatives ahead you plan to invest more for in 2015.

  • So Jay or Roger, can you talk a little bit more about that, what we expect to see and would we expect to see some of the benefit of that impacting 2015.

  • - COO

  • So John, --

  • - Analyst

  • Hi, Michael.

  • - COO

  • Hey, how are you?

  • - Analyst

  • Good.

  • - COO

  • We're doing quite a bit under the umbrella of our omni-channel initiatives to try to give our customer a better experience and also leverage the capabilities we have as a company.

  • We're thrilled with our ship from store roll-out that we've been working on all year.

  • We're in about 530 stores.

  • We've learned quite a bit about this technology through the year, how to manage the algorithms to drive profitability and we're very pleased by the volume that's been generated and the ability to better service our customers.

  • We now, during holiday, we have it targeted on unproductive inventory in lower volume stores that are within two day shipping of our customers and we're seeing great results.

  • We plan to roll that out to the balance of the chain next year.

  • The team's done a tremendous job.

  • The stores are fulfilling these orders very quickly, training stores very nicely and we think there's a huge benefit there for our customers.

  • We're going to roll out reserve in store next year, which we think is going to be a big win.

  • A big part of our customer base doesn't even have credit cards.

  • So the ability to be on their device, identify something they want to buy and then go to store, pick it up, pay cash, we think is going to be a huge win for us.

  • We rolled out new digital capabilities, both in improved mobile -- improved website as well as a new mobile app in the last quarter and why that's critical, John, is we updated that app eight times in the quarter.

  • Okay.

  • We were able to do that because we built it in-house and we own that technology.

  • Previously, we were only able to update about eight times a year.

  • Okay.

  • So as quickly as traffic's driving to mobile, we're able to meet and exceed customers' expectations with that new technology and it's only the tip of the iceberg.

  • The last thing is we went into pilot in the back half of the year with a new point of sale system.

  • It's only in about 10 stores today, but we plan to roll it to the entire chain next year and there's two key capabilities in that that Simon and I and the team are very excited about.

  • One is we're going to have mobile checkout in all stores, so the ability to check a customer out through either an iPad or an iPod in the stores.

  • The second is the ability to save a sale from those same devices.

  • So an associate with a customer, we don't have their size in store, they can look it up on the iPad, see if we have it in another store or in our DC and ship it to a customer's home.

  • Operator

  • Thank you.

  • The next question is from Neely Tamminga of Piper Jaffray.

  • Please go ahead.

  • - Analyst

  • Great.

  • Good afternoon.

  • One quick point of clarification on the SG&A, just want to make sure I heard that correctly: SG&A dollars, rate or both for being flat to down slightly for next year, Mary?

  • Roger, for you, we've heard a lot about joggers and jeggings and leggings.

  • I don't know if I could say that again that fast.

  • But I'm wondering, what are the kiddos wearing it with?

  • What's going on with tops?

  • What tops should they be wearing?

  • What business should be better in tops?

  • - Chief Creative Director

  • If I told you what they should be wearing with tops, I'd be giving too much information out.

  • - Analyst

  • Joggers, jeggings and leggings, all right.

  • - CFO & Administrative Officer

  • SG&A next year flat dollars, flat to slightly down dollars for 2015.

  • Operator

  • Thank you.

  • The next question is from Kimberly Greenberger of Morgan Stanley.

  • Please go ahead.

  • - Analyst

  • Thank you so much.

  • My question is on traffic.

  • Clearly the traffic is suffering today because you're pulling back on the promotional activity, but you'll anniversary that in the second quarter next year.

  • Beyond Q2 in 2015 how do you expect your traffic trends and your transaction count in-store to trend?

  • Thanks.

  • - Chief Creative Director

  • It's difficult to forecast out, as you know, very difficult.

  • My sense is that when you take the transactions online and you take the transactions in the stores and you put it together, if we're the compelling lifestyle brand that I think we are at this moment vis-a-vis the competition and how much better we can be when we do much better as we move forward, I would think that the combination, our traffic should start to turn upward.

  • Operator

  • Thank you.

  • The next question is from Jennifer Davis of Buckingham Research.

  • Please go ahead.

  • - Analyst

  • Hey, guys.

  • Good afternoon.

  • And Jay, I will say I agree, the merchandise is much improved from nine months ago and that Denim X is really great.

  • - Interim CEO

  • Thank you.

  • He won't beat me up after this call.

  • ( Laughter ).

  • - Analyst

  • That's the softest denim I've felt.

  • - Interim CEO

  • Wait until you see 4X.

  • - Analyst

  • Okay.

  • Quick clarification on merchandise margins, if you could.

  • How much of the merchandise margin increase was based on a reduction in markdowns and how much on AUCs?

  • - CFO & Administrative Officer

  • For Q3 it was mostly markdowns.

  • - Analyst

  • Okay.

  • - CFO & Administrative Officer

  • Almost entirely markdown driven.

  • - Analyst

  • Okay.

  • - Chief Creative Director

  • As Michael said, we really improved the fabrics, the washes, the quality of the make.

  • So we were able to hold our cost pretty flat, which is terrific.

  • But going forward, Michael's going to have great improvement with the currency and cotton changes.

  • - Analyst

  • Okay.

  • So you've actually increased the quality but held the cost current.

  • - Chief Creative Director

  • That's correct.

  • - Analyst

  • Okay.

  • All right.

  • Operator

  • Thank you.

  • The next question is from Rebecca Duvall of BlueFin Research.

  • Please go ahead.

  • - Analyst

  • Hi, guys.

  • Let me add my congratulations as well for managing through a tough environment.

  • Roger, my question is for you.

  • I know you don't like to give too much away, but we saw a lot of success with some of these capsules that you were bringing into the stores with the Artisan De Luxe, the 40 West, the Don't Ask and it seemed like you were able to get away with some premium retail.

  • My question is, can we expect to see more of that go forward and is there plans to be rolling that out in more doors as well?

  • - Chief Creative Director

  • We're very happy with what it does and actually, Jay and I just went through our concept for holiday for next year and the collaboration and those capsules are better than ever.

  • They always will only be a small part of the business, but when it inspires the inspirational part of the store and it gives us that fizzle that we absolutely need to have and we need to have more of it.

  • We certainly are going to continue to it but it will be contained.

  • It's great information, not as exciting for the customer, but it's great information for us.

  • Operator

  • Thank you.

  • The next question is from Jennifer Black of Jennifer Black & Associates.

  • Please go ahead.

  • - Analyst

  • Good afternoon and let me add my congratulations as well.

  • We're seeing a bigger assortment of accessories and I wondered what percent of your business accessories represent now and where could we see that go?

  • Then I have a follow-up on what kind of a comp do you need to get leverage in 2015?

  • Thank you.

  • - CFO & Administrative Officer

  • The comp leverage is probably low single digits.

  • - Chief Creative Director

  • Accessories will continue to grow.

  • - Analyst

  • And you're not going to say what percent they are now?

  • - Chief Creative Director

  • No.

  • - Analyst

  • Do you have substantial room for growth?

  • - Chief Creative Director

  • Yes, we do.

  • Substantial.

  • Operator

  • Thank you.

  • The next question is from Dorothy Lakner of Topeka Capital Markets.

  • Please go ahead.

  • - VP of IR

  • Dorothy, are you there?

  • We'll take the next question, Manny.

  • Operator

  • Certainly.

  • The next question is from Lorraine Hutchinson from Bank of America.

  • Please go ahead.

  • - Analyst

  • Thank you.

  • Good afternoon.

  • Mary, with CapEx coming down next year, can you review your view on priorities for free cash flow?

  • - CFO & Administrative Officer

  • You know, I think it's, again, about our product, our assortment, making sure our stores reflect a great customer experience, continuing to invest in the Company, open stores, et cetera.

  • I think as I look at kind of our plan for next year and where we're investing, it is really around those priorities, plus in the digital space where as Michael articulated earlier on the call, lots of great investments that we have going forward that are needed for the Company to get competitive and hopefully gain a competitive advantage.

  • I think it's all about investing in the Company and in investing in areas that will help drive profitable growth for the company as we look forward.

  • - VP of IR

  • Manny, we'll take one more question.

  • Operator

  • Certainly.

  • The next question is from Marni Shapiro of The Retail Tracker.

  • Please go ahead.

  • - Analyst

  • Hi, guys.

  • Thanks.

  • In case I forget, best of luck with the holidays.

  • The stores look great.

  • You mentioned that some t-shirts and knits and fleece had been a tougher part of the business, but how much of the softness in that space is due to headwinds from the trending down logo business?

  • And how much less logo business do you have in the stores today even versus last year where you were kind of blowing out some of it at decent prices.

  • - Chief Creative Director

  • The logo business as such for us has never been a huge part of the business.

  • It was not how we wanted to build the business.

  • I never believed in taking the eagle and spraying it across the chest, other than in graphics with T's and fleece.

  • At this point it represents under 10% of our business and obviously the trends are a bit less.

  • Our eagle is a very powerful icon on a global stage and I believe in the eagle very strongly.

  • You would never see Ralph take his polo player off.

  • I don't think you should expect to see American Eagle take the eagle off of its garments.

  • But as it relates to the whole graphic, that is something we've never really been in a big way.

  • I don't believe in that.

  • Operator

  • Thank you.

  • That was all the time we have for questions.

  • I would like to turn the floor back over to management for any additional or closing remarks.

  • - Interim CEO

  • Thank you for your time today.

  • We look forward to delivering improved profitability and stronger shareholder returns.

  • We wish you all a happy holiday season.

  • Thank you.

  • Operator

  • Thank you.

  • Ladies and gentlemen, this does conclude today's teleconference.

  • You may disconnect your lines at this time.

  • And thank you for your participation.