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Operator
Good morning.
My name is Brandy and I will be your conference facilitator today.
At this time I would like to welcome everyone to the American Eagle Outfitters second quarter earnings conference call.
All lines have been placed on mute to prevent any background noise.
After the speakers' remarks, there will be a question-and-answer period.
If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad.
If you would like to withdraw your question, press the pound key.
I would now like to turn the call over to Mr. Jim O'Donnell, Chief Executive Officer of American Eagle Outfitters.
You may begin, sir.
- CEO
Thanks, Brandy.
Good morning, everyone.
Other participants today include Roger Markfield, Laura Weil, Susan McGalla and Michael Leedy.
If you need a copy of our second quarter press release it is available on our website, ae.com, or you can call Cindy Jones at 724-779-5251.
Before we begin I need to remind everyone that during this conference call members of management will make certain forward-looking statements based upon information which represents the Company's current expectations or beliefs.
We caution investors that actual results may differ materially from those expectations or beliefs based on the risk factors described in our quarterly and annual reports filed with the SEC.
Needless to say I'm extremely pleased with our second quarter financial results.
Sales and earnings have exceeded our expectations, strong product assortments have reduced markdowns with the drivers of positive comparable store sales.
Across our Company, we are operating more efficiently.
Process improvements and strong operating disciplines are yielding record-breaking results.
Our merchandise assortments are fashion right and perfectly geared towards our 15 to 25 year old target customer.
We continue to have focused assortments with brand defining key items which have been driving the significant improvement in our business.
Second quarter sales rose 22.8% to 414 million, led by a 13.8% comp increase for the American Eagle brand.
Similar to the first quarter, second quarter sales strength was broad-based, with all geographic regions producing a double digit comp increase.
The majority of the merchandise categories were also positive, which Roger will outline in detail later.
Our gross profit margin increased 670 basis points, with gross profit rising 48% over last year.
Strong sell throughs and significantly lower markdowns drove the profit improvement.
Expenses continued to be well managed.
Our operating margin grew to 11.6%, our highest second quarter margin since 1999.
Cash flow is strong, with cash and short-term investments totaling $332 million, rising 124 million from the end of the second quarter of last year.
Now, a few store highlights.
Through the end of the second quarter, we opened 21 U.S. locations and closed 4 underperforming stores.
In Canada, we opened 4 AE stores and closed 1.
At Bluenotes we opened 1 store and closed 4.
Our total squire footage increased 8.5% over last year and we are on track to open 26 additional stores.
We remain quite pleased with our new store performance.
So far this year, at 51 new 2003 stores have achieved over 95% of the sales per square foot of the mature store base.
New markets, including Hawaii, and Puerto Rico, continue to exceed our expectations.
Last month, we also opened 4 new stores in Quebec to an enthusiastic response.
In fact, it was our strongest opening ever in Canada with all 4 stores vastly exceeding our sales forecasts.
We are also very pleased with our renovated stores where sales increases are consistently trending approximately 15 points higher than the comp base.
Second quarter sales results or trend, excuse me, at Bluenotes have been inconsistent, yet operating margins continue to improve due primarily to lower margins.
In the second quarter, the business lost 3 cents per share compared to 4 cents of a loss last year.
While we're obviously not satisfied with this performance, we continue to manage the business prudently and work towards achieving stronger operating results.
Lastly, I would like to comment briefly on current business and our long-term growth strategy.
We are very pleased that sales trends accelerated with our back to school assortment which arrived in stores during the second week of July and sales momentum has continued into the first 11 days of August.
We're enthusiastic about our merchandise for the back half of the year, and we believe have tremendous opportunity to continue building market share.
With the American Eagle business now on track in achieving strong earnings and positive cash flow, we are pursuing a second U.S. strategy.
We currently have a small team in place working on a concept.
We're all very excited about moving forward with a new opportunity and look forward to achieving continued success and growth in the future.
Now, here is Roger.
- Vice Chairman & President
Thanks, Jim.
Good morning, everybody.
I'm absolutely delighted with our second quarter performance.
Our stores were focused, colorful, featuring strong key items, and delivering great value.
We continue to offer a strong value message through AE brand defining items such as denim, graphic and polos.
Our spring and summer assortments were very well received by our target customers.
Second quarter sales strength was broad-based, across both men's and women's.
Our men's business achieved the low double digit comp increase over last year.
Most merchandise categories were positive.
We are pleased by the progress we're making in the men's business.
That improvement comes from key design initiatives and changes to fits, fabrics, and styling and we are excited about the men's fall line which has continued to gain momentum.
Our women's business comped in the mid teens during the second quarter, reflecting strength essentially across the board.
We continue to execute very well on pretty, feminine, colorful fashions.
At the same time, we're branding core classic items like polos, layering tees, and denim.
We've been pleased with our newly designed accessory assortment, which has added energy to our store presentations and significant productivity gains in the back of our stores.
Our sales metrics were positive during the second quarter driven by a high single digit increase in our average unit retail price.
And most importantly, the number of transactions per store also rose in the high single digits.
Units per store were up in the high single digits and units per transaction declined slightly as a result of less clearance versus last year.
Our gross margin improvement was driven by a 550 point basis point improvement in merchandise margins.
Our markdown rate dropped significantly due to fewer markdowns and much less promotion.
We did not anniversary several coupon distributions and clearly in view of the success of our back to school assortment, we will continue with a less promotional stance.
In fact, we did not anniversary our friends and family event that we held last August.
As we indicated in our July announcement, sales strengthened in the second week of July with the arrival of our back to school assortment and we are most pleased to say that strength has continued into August.
We believe that the fashion is right on for our target customers, in terms of the colors, silhouettes, details, and fabrications.
The cornerstone of the line is denim, which is and has been quite strong for us, both men's and women's.
It has been a strategic goal of the Company to be the very best at denim, with the best style, fit, quality, and value for our target customer.
Everyone across our Company is working more creatively and productively than ever before.
That's a key factor of our current success.
Another is brand strength and customer loyalty.
Despite the challenges we faced last year, our customers kept coming.
Now, they are voting yes to the merchandise assortments.
We believe that American Eagle is the dominant go to brand for the widest segment of high school and college students.
We are in a good position with our customers, we have the talent, disciplines, and process in place.
We look forward to our future and we will work very hard at maintaining the momentum behind the American Eagle brand.
Thank you, now here is Laura.
- EVP & CFO
Thanks, Roger.
Good morning, everybody.
I am also extremely pleased with our record results this quarter.
Our strong margin performance demonstrates the opportunity we have for continued profit improvement.
In the quarter, we achieved our goal of driving top line sales growth while maintaining fast inventory turns.
We continued to control our expenses.
We leveraged rent, store payroll, and advertising costs.
And we significantly lowered our markdown rate as a result of solid merchandise assortments and careful inventory planning.
Looking out to the end of this fiscal year and 2005, we maintain our goal of achieving a 12 - 14% annual operating margin.
Our performance this quarter was consistent with that goal.
Now, I will review the second quarter details.
Total consolidated sales increased 22.8% to $413.8 million from $337.1 million last year.
Total sales included $18.4 million from the Bluenotes chain.
Second quarter comparable store sales for the American Eagle brand increased 13.8% compared to a comp decline of 5.3% in the second quarter last year.
Consolidated comps increased 12.7%.
Comps for the Bluenotes stores declined 4.2%.
We achieved our highest second quarter gross margin rates since 1999, averaging 670 basis points to 39.7% from 33% in the second quarter last year.
The higher rate reflected an increased merchandise margin, which was primarily due to lower markdowns compared to last year.
Our IMU improved 160 basis points due to lower merchandise costs as well as initiatives to control freight and reduce sell-offs.
Within the gross margin, we also leveraged buying, occupancy and warehousing expense by 120 basis points due primarily to the leveraging of rent.
By division, the American Eagle brand and Bluenotes both contributed to the improvement in the gross margin.
We leveraged SG&A expense by 80 basis points over the second quarter last year, declining to 24.4% of sales from 25.2% last year.
Within SG&A advertising, communication, and leasing costs leveraged as a result of our ongoing expense control initiatives.
We also leveraged home office and store salaries.
These improvements were partially offset by accruals for incentive compensation, an expense we did not incur last year.
Excluding incentives, SG&A dollars increased 6% which was less than our square footage growth of 8.5%.
Our operating income margin increased 790 basis points to 11.6% from 3.7% last year, our highest second quarter rate since 1999.
Other income totaled $520,000 compared to $514,000 last year, reflecting increased interest income due to a higher cash balance.
Net income for the quarter increased 266% to $29.6 million compared to $8.1 million last year.
Fully diluted EPS rose nearly four-fold to 40 cents from 11 cents last year.
Our balance sheet remains very strong.
We ended the period with 332 million in cash and short-term investments, an increase of 124 million from the end of the second quarter last year.
We also have 26 million of long-term investments consisting of fixed income securities with maturities of less than two years.
Total consolidated merchandise inventories were up $10.8 million to 170 million at the end of the quarter.
U.S. inventory per square foot at cost was down 2% to last year, however, units were -- units per foot were up 6%.
We are comfortable with our inventory position and we are receiving receipts in August to support current sales trends.
Our inventory turn through the end of the second quarter improved by 12%.
Looking out to the end of the third quarter, we expect U.S. inventory at cost per foot to be up in the low single digits.
Capital expenditures year-to-date totaled $52 million related to our new and remodeled stores as well as the purchase of our home office building, which totaled $20 million.
For the year, we are still planning capital expenditures to be approximately 85 to $90 million.
Now, regarding our outlook.
We are very pleased by the current pace of business and the good response to our back to school assortment.
At this time we are comfortable with the third quarter First Call mean estimate of 47 cents per share compared to earnings of 14 cents per share last year which included a goodwill charge related to Bluenotes of 11 cents per share.
Thank you and now we'll open the call for questions.
Operator
At this time, I would like to remind everyone, in order to ask a question, please press star, then the number one on your telephone keypad at this time.
We will pause for just a moment to compile the Q&A roster.
Your first question is from the line of Janet Kloppenburg of JJK research.
- Analyst
Good morning, everyone, congratulations.
- EVP & CFO
Thanks, Janet.
- CEO
Morning, Janet.
- Analyst
Roger, I was pleased to hear what you said about the current business trends because we're hearing from other people that the late Labor Day shift may have some effect on trends in August, pushing some business into September.
I wonder if you could talk a little bit about that?
And I'd also wondered if Jim could talk a little bit more about the timing of the second U.S. strategy, the U.S. concept, and if he could comment on the likelihood that Bluenotes would stay in your stable of brand portfolio?
Thank you.
- Vice Chairman & President
Janet, we're not -- we're not seeing any evidence of a slowdown in the business based on the change of the calendar and if the other competition is right, we will get the benefit in September.
- Analyst
Do you think that other people's denim inventories are not as strong as yours and therefore, you're taking some share there, Roger?
- Vice Chairman & President
You know, I don't like to respond about our competition, Janet.
- Analyst
Okay.
Thank you.
- Vice Chairman & President
Thank you.
- CEO
Janet, regarding the timing.
Since it's in its early stage right now I would anticipate that the earliest we could get one or two of the stores open would be in holiday '05, more like spring '06, but that's best guess I have right now.
And on Bluenotes I've been pretty public with evaluating that strategy, after back to school, we still have another three to four weeks that I need to look at and I will be making a decision upon the completion of the BTS at Bluenotes in Canada.
- Analyst
At the end of the back to school season you will be making a decision?
- CEO
Back to school for, right.
Uh-huh.
- Analyst
Congratulations.
Thank you.
- CEO
Thank you.
Operator
Your next question is from the line of Stacy Pak of Prudential.
- Analyst
Hi, just one followup on Janet's and then my own question.
On the month to date sales are they like the last week or all month, either of which obviously were huge?
And then just on the guidance, the gross margin was enormous, up 670 basis points.
How can you only be comfortable with third quarter consensus of 47 cents?
Maybe you could talk a little bit about the gross margin and SG&A, you know, components we should think about for the back half, including, you know, is IMU up 160 again, how about merchandise margin versus 99?
And then bigger picture, as part of that question, another company that reported last night talked about extra costs associated with the upcoming elimination of quota.
Do you have any extra costs from that, higher air freight?
Anything we should think about there, have you switched country, et cetera?
- EVP & CFO
You asked a lot of questions, Stacy.
- Analyst
It is really only two.
Guidance and sales.
- EVP & CFO
Yeah, I don't know if I can -- I am going to address sales and I'm going to address guidance.
- Analyst
Okay.
- EVP & CFO
Sales trends, we said, continued to be very strong and at this point, we -- and we said that we were not being affected by the shift of a late Labor Day.
We only have a few regions that will have that shift and we're not seeing the impact.
So -- and as Roger said, if we do, then we will see -- we 'll see some better sales in the first two weeks of September.
On the guidance, you know, the consensus, we agreed with the consensus.
What we would like to do is be conservative and we would like to adjust our guidance at the end of August.
We think it is early.
But we do think that - that the trends in our business are continuing and you should do your own numbers and make your own assessments, but we will update our guidance at the end of August.
- Analyst
But Laura, you didn't answer -- I mean the components, is the IMU in the back half up like it was in Q2?
Where is the merchandise margin expected to be versus '99?
And do you have any extra expenses associated with the elimination of quota?
- EVP & CFO
We have no additional expense related to quota.
I just said that I'm not giving, you know, the full guidance right now.
I think you should take the trends and you should extrapolate your own numbers and we will give guidance at the end of August.
- Analyst
Okay.
- EVP & CFO
And obviously, we think, you know, our merchandise assortments are very solid, very strong, and we think that there is good upside potential in the gross profit, but we're not putting an exact number on it right now.
- Analyst
Okay.
Thanks.
- EVP & CFO
Okay.
Operator
Your next question is from the line of Jeff Klinefelter of Piper Jaffray.
- Analyst
Yes, congratulations on a great start to the back to school season.
First of all, two quick questions.
One on, Roger, on the mix of denim.
You know, we're hearing, obviously, great things about denim out there and particularly washes and vintage washes, could you talk a little bit about the mix of your what quote fashion to basic denim within the assortment?
And then a little bit of granularity on kind of a average retail price points this back to school season versus last back to school season in denim?
And then one other one would be on the square footage growth, I mean ex your new concept, you know, next year what should we be looking for in terms of kind of a -- an average square footage growth rate?
- Vice Chairman & President
Jeff, as I said before, we're really -- denim is the cornerstone of our business.
I think if you -- and you've been am our stores, you see how strong our presentation is, we've hit the styles in the right fit, in the right color, in the right washes.
Our starting price point on a normal basis is 29.50 and we go to $48.
And we're really pleased with the customers' acceptance for the line.
- CEO
On the growth rate, Jeff, probably should be looking at around -- approximately 7%.
Most of our growth rate next year we fuel -- still fueled by new stores which we would approximate somewhere around 30 to 35 but with an accelerated expansion program of probably 60 stores which we're actually putting together the final plans tomorrow.
So, but I think you're safe in about 7%.
- Analyst
Great.
Thank you.
- CEO
You're welcome.
Operator
Your next question is from the line of Kimberly Greenberger of Smith Barney.
- Analyst
Great, thank you.
Good morning and I will add my congratulations as well.
- CEO
Thank you.
- EVP & CFO
Thank you.
- Analyst
Laura, I'm wondering if you can give us a little bit more clarity on the SG&A.
The incentive comp accrual that you took here in the second quarter, does that account for incentive compensation year-to-date or was that just attributable to second quarter?
And if you could just speak to second half of 3Q and 4Q SG&A growth rate either with or without incentive comp, that would be very helpful.
Thanks.
- EVP & CFO
Okay.
The way we accrue the incentives is on the earnings to date.
So we only accrue to the extent we earn and then it is based on a target level of earnings.
So we have accrued based on our target level that we will pay compen -- incentive compensation on.
SG&A for the back half -- for the third quarter is expected to be up roughly mid teen and that would include incentives.
By the fourth quarter we might have less -- or less incentives to accrue and I think that SG&A will be up in the mid single digits.
On a dollar basis.
Dollar increase.
- Analyst
Okay.
Great.
And then just one last question.
If you could tell us if there is any goodwill left on your balance sheet associated with the Bluenotes business?
- EVP & CFO
There is no goodwill left.
- Analyst
Okay.
Thanks, Laura.
- EVP & CFO
Thank you.
Operator
Your next question is from the line of Adrienne Tennant of Wedbush.
- Analyst
Good morning and congratulations on a great quarter.
- CEO
Thank you.
- Analyst
Just a couple of questions.
Can you remind us what the dilutive impact of Bluenotes was in Q1 this year versus last year?
And then if you can give any color on the direction of the new concept, maybe what target market it might be going after, if you have direct sales if you could break out?
And then finally, can you just talk about target margins kind of the business model in the longer term because we've made such great success this year.
Thank you.
- EVP & CFO
I will talk about the Bluenotes dilution.
This -- in the first quarter, Bluenotes lost 2 cents versus last year 5 cents.
And in the second quarter, Bluenotes lost 3 cents versus 4 cents last year.
You want me to talk about margin or -- ?
In terms of the margin, overall margin goals, you know, we have stated and I stated in my comments that we were targeting 12 to 14% annual operating margins.
And that will deliver very healthy earnings growth over the next couple of years, excluding any other growth initiatives.
So we're on track with that, with the performance year to date in the first and second quarter, we have every belief that -- that our third and fourth quarter will be good but we don't have a crystal ball and it is only 11 days into the third quarter.
So I will say that we are on track for our goals.
- Analyst
Okay.
- CEO
Regarding new concepts, for competitive reasons, I would prefer not to state anything particularly -- finite right -- at the current time but I will say that, you know, more to come later.
It is still in its early stages and to say anything right now would be a little premature so we will hold till a later date.
- Analyst
Okay.
Great.
Thank you.
- CEO
You're welcome.
Operator
Your next question is from the line of Jennifer Black of Jennifer Black and associates.
- Analyst
Good morning.
And let me add my congratulations.
- CEO
Thank you.
- EVP & CFO
Thanks, Jennifer.
- Analyst
I wondered if you could talk about what percent of your merchandise was accessories?
What percent you would foresee in the third and in the fourth quarter?
Because you guys have done such an excellent job with your accessory business.
- Vice Chairman & President
The accessory business was about 15% of our business in the spring season and in the fall season it will be around 17%.
- Analyst
And does that include shoes, Roger?
- Vice Chairman & President
No, it does not.
- Analyst
Okay.
And could you also speak to shoes?
- Vice Chairman & President
Shoes runs around 4 to 5% of our business.
- Analyst
And would you expect that to go up in the fourth quarter?
- Vice Chairman & President
Probably slightly.
- Analyst
Okay.
And are there any new categories coming for the fourth quarter?
- Vice Chairman & President
Many new categories.
- Analyst
Okay.
Thank you.
Good luck.
- Vice Chairman & President
Thank you.
Operator
Your next question is from the line of Joe Teklits of Wachovia.
- Analyst
Hi, guys, good morning.
- EVP & CFO
Good morning, Joe.
- Analyst
What a difference a year makes, huh?
- CEO
Thanks, Joe.
- Analyst
A couple of question, I guess maybe for Laura.
First of all it sounds like your renovated stores are throwing off a great performance.
Can you -- can you just update us on how many you're doing this year, if you're -- if most of them get included in -- in the comp results, and whether you might think about accelerating that going forward?
And also, the inventory down 2% in dollars, up 6% in unit, is that just a cost differential -- ?
- Vice Chairman & President
That's correct.
- Analyst
If you could put that in perspective, Laura .
- EVP & CFO
Sure.
You want to answer that?
Jim's going to talk to you about the renovated stores.
- CEO
On the renovated stores, stores that exceed a 25% growth of square footage are not in the comp.
We have -- of the 47 or 48 that we have that we renovated, or will renovate, there are 6 that are in the comp because we did not increase the square footage.
We did what we call a minor remodel and there were no expansion.
And 5 of those 6 stores are performing at double digit increases.
So, we're very pleased with our results of both the expanded stores as well as the stores that do not qualify for additional square footage.
- EVP & CFO
And as Roger just mentioned to you, yes, the inventory costs is lower because of lower cost, lower cost factor.
- Analyst
So if we looked at like a retail dollar inventory number, if that's the right terminology, I know you look at it differently sometimes, Laura --
- EVP & CFO
It would be flat.
It would be flat.
- Analyst
It would be flat in stores today?
- EVP & CFO
Uh-huh.
- Analyst
Okay, thanks.
Good luck.
- EVP & CFO
Thank you.
Operator
Your next question is from the line of Steve Backus of Buckingham Research.
- Analyst
That's Lee Backus.
Let me add my congratulations.
First, Roger, could you really -- you could address the denim market?
We seem to be in a very strong fashion cycle right now in the denim market.
You know, is this -- is this something that you think is going to continue?
Is this just the way it is?
Or just could you comment on the denim market?
- Vice Chairman & President
I've been asked that question since '76 when I was at The Gap, Lee.
Denim is very a important ingredient of the lifestyle of our customer target.
It is today and it will always be.
- Analyst
So, I mean, this-- you don't see this then as a fashion cycle.
You think this is just the way it is and this will continue?
- Vice Chairman & President
That's correct.
- Analyst
Could you also address -- I think you're trying some additional sizes on the girl's side.
Could you -- or testing some additional sizes.
Could you talk about those?
- Vice Chairman & President
I'll let -- I'll let Susan give you some color on that.
- EVP & Chief Merchandising Officer
Lee, a couple of things that we're doing in the denim is we are expanding and doing more of our offerings in our jean choices in lengths so that is something that the girl clearly told us that she likes to be able to have the choice of short, regular or long.
That is working famously for us right now.
And then we are trying some things on the lower end of the size scale right now but it is very premature.
We are still reading, you know, some of the tests.
- Analyst
Okay, thank you.
Operator
Your next question is from the line of Tom Filandro of Susquehanna.
- Analyst
Hi, two questions.
First, Laura, can you address any thoughts on the cash position and what you might do with that cash?
And then, the second question is sort of a general question about just remind us about outerwear, the performance last year, maybe some representation of the third and fourth quarter, and expectations of changes in that category for '04.
Thank you.
- EVP & CFO
On the cash side, we -- as you noted, we are in a strong cash position.
And we're evaluating -- not only are we going to invest our cash obviously in growth initiatives, as Jim mentioned, and capital expenditures and improvements in our existing business, but we will look at ways to increase shareholder value, including dividends and share buybacks.
- Analyst
Thank you.
- EVP & Chief Merchandising Officer
And I will speak, Tom, to you about the outerwear for the back half of the year.
A couple of misses that we had last year were some fashion misses, let me give you an example on the women's side.
I think we had a lot of masculine kind of styles that we were representing and I don't -- I don't think that we also had what the girl or the guy is used to coming to us for, I think we disappointed them.
Some things that we are adjusting for the back half of this year in outerwear are -- there's some more wear now trends supporting some things in outerwear that we think will help our October and early November businesses.
And we're also holding back a little bit of newness so when you get into holiday there will be some new offerings that will be offered at the right time, seasonably appropriate, and satisfying again some of the things I think we disappointed them on last year.
- Analyst
Can you tell us, Susan, maybe how outerwear performed as a category last year?
- EVP & Chief Merchandising Officer
It was -- it was diffi -- it was difficult.
- EVP & CFO
It was disappointing.
- Analyst
No specific numbers, though?
- EVP & Chief Merchandising Officer
No.
- Analyst
Okay.
Thank you very much.
Good luck.
Operator
Your next question is from the line of Richard Baum of CSFB.
- Analyst
Good morning, everybody.
- EVP & CFO
Good morning, Richard.
- CEO
Good morning.
- Analyst
Congratulations.
- CEO
Thank you.
- Analyst
Just two questions.
One, a clarification.
Jim, you talked about new store growth accelerating to 60.
Could you just clarify what the total expected new store openings are this year on a -- basis?
- CEO
First of all, Richard, I think 60 was for remodels, 30 to 35 new for '05.
- Analyst
Is that gross or net?
- CEO
That will be net.
- Analyst
And so how many closings are in there?
- CEO
Probably 4 or 5.
We're looking at that literally as we speak right now.
I just got the latest list of leases that come up for renewal.
- Analyst
Okay.
And then secondly, could you just talk, I guess this maybe is a Roger question, in terms of marketing for the second half of this year, could you talk about what the line-up is this year versus last year?
- Vice Chairman & President
Richard, I'm going to pass that to Michael Leedy.
- Analyst
Oh, perfect.
I forgot Michael was there.
I'm sorry.
- Chief Marketing Officer & EVP of Strategic Planning & E-Commerce
That's all right, Richard.
Hey listen, we're extremely excited about what we have going on right now in back to school.
The AE jeans will rock you campaign kicked off and really with great product and great marketing and get great results.
You know, we're doing things like continuing to update our online denim guide at AE.com to make it better.
I think we have one of the best online denim guides out there.
I also think we probably have the best or one of the best denim presentations in the malls with, you know, with great marketing.
We are running television spots currently on MTV, shows like TRL, Punked, Cribs and of course Road Rules.
We sponsor Road Rules so we have product placement on Road Rule, pretty extreme product placement.
We have 3 second spots surrounding the show and on air mentions of AE at the end of each show.
This campaign will run to September 13.
Also, we're going to do television around the video music awards on MTV, a special buy, that runs on August 29.
The VMAs is kind of like the Super Bowl for our customers on MTV in the back to school time period, so we're very excited about that.
Additionally, magazine advertising in key books for us during the back to school time period and at holiday, getting a lot of editorial coverage in magazines this year.
We had 17 different mentions in, ironically, 17 magazine September issue.
You know, I don't know what that means, 17 and 17, but it was -- it was wonderful to get that kind of coverage.
And then the only other thing I would tell you, the only other -- the few things I would tell you is in the next couple weeks, to keep the momentum moving, we have parties planned in L.A., Chicago, and New York, with really the hottest college bands for our customers, celebrating AE jeans will rock you.
We have a custom guitar that were designed by these bands that we are going to auction off on eBay and ae.com to raise money for VH 1 save the music which I think is, you know, a wonderful thing for us to do and also I think we are going to get a lot of local media coverage in those major markets and also national coverage.
And the very last, you know, thing rolling into holiday, and I'm not going to give away any of the holiday things, but we have a lot of great things also planned for holiday.
We are going to continue to take market share in the denim business by extending our denim marketing a little bit further into fall.
In 25 to 30 major college stadiums we are going to do in stadium marketing.
A number of times during each game, and I'm talking about schools like Michigan, Penn State, Boston College, USC, big schools, a number of times during each game there will be mentions of AE.
When they play we will rock you, which is the great stadium anthem, they are going to say that's brought to you by American Eagle Outfitters, AE jeans will rock you.
There will also be some product give aways as well.
So, thanks a lot.
- Vice Chairman & President
Just bottom line on this, in terms of the expense of the third quarter versus last year on marketing initiatives?
- Chief Marketing Officer & EVP of Strategic Planning & E-Commerce
It is down on a -- on a dollar basis and at this point also, obviously, down on a percent to total basis.
- Analyst
And that is because -- did you do something last year that you spent a lot of money on?
- Chief Marketing Officer & EVP of Strategic Planning & E-Commerce
Well, Roger mentioned it in his opening remarks.
I think we're really strategically using CRM, customer relationship marketing, direct mail, much, much better, you know, in the second quarter we actually distributed 50% less coupons.
- Analyst
Okay, great.
- Chief Marketing Officer & EVP of Strategic Planning & E-Commerce
Thank you.
Operator
Your next question is from the line of Frank O'Dowahar of Jefferies and Company.
- Analyst
Good morning.
Congratulations, everybody.
- CEO
Thanks, Michael.
- EVP & CFO
Hi, Michael.
- Analyst
Got a couple of merchandising questions.
As I look to what is going to drive the fourth quarter, historically when denim and knits are happening for back to school those tend to transition pretty well in the fourth quarter, first of all, Roger, has that been your experience in general?
- Vice Chairman & President
Yes, we agree but as you know, sweaters is the key in women's.
- Analyst
Right.
Any early results on the few girl's sweaters?
- Vice Chairman & President
I will let Susan give you some color on that.
- EVP & Chief Merchandising Officer
Michael, I'm not going to give you too much color, but as you know, and we've talked about -- we have a pretty sophisticated testing strategy here.
- Analyst
Right.
- EVP & Chief Merchandising Officer
And we have pulled a lot of holiday products up early to position our assortments just right for holiday and we have done that.
- Analyst
Okay.
Great.
And hoodies last year wasn't executed all that well.
This year they look much better.
Is it fair to say that the hoodies for Q4 this year, chance to perform pretty well versus last year?
- Vice Chairman & President
I would say so.
- Analyst
Can I kind of pencil that in as a --
- Vice Chairman & President
Yes, you can.
- Analyst
Okay.
Great.
One more question.
What is that apartment site on the website and can I read anything into that test?
- Chief Marketing Officer & EVP of Strategic Planning & E-Commerce
This is Michael Leedy and, Michael, you shouldn't read anything into it.
I want to make it clear to everyone, that is not really our new concept.
That is a test and a test only for AE.com.
- Analyst
Okay.
Congratulations, everybody.
Thanks a lot.
- EVP & CFO
Thank you.
- Chief Marketing Officer & EVP of Strategic Planning & E-Commerce
Thank you.
Operator
Your next question is from the line of Lauren Levitan of SG Cowen.
- Analyst
Thanks, good morning.
Laura, you gave the breakdown of what your expense growth would have been, excluding incentive compensation, and it's extremely lean as it has been the last couple of quarters.
Can you give us a sense of how much additional potential there is in that kind of expense control and what it might mean about a long-term operating margin target possibly over and above the 12 to 14% that you discussed this morning?
Thanks.
- EVP & CFO
Yeah, we -- we've really put in some, I think, long-term expense controls.
We've reduced our communications expense and leasing costs and a number of -- and freight costs.
And I think these are expense initiatives that will continue.
Next year -- the big -- the big difference between this year and the last two years is really the incentive accruals.
And next year, I mean, we would love to have the same level of incentive accruals, but, you know, this is just a very big leap from the prior year in terms of our earnings growth, so next year, I would expect our earnings accruals to be lower.
So I think overall SG&A growth, you know, should be, I hope, in the mid single digits next year in terms of dollars, mid to, you know, I think mid single digits.
Maybe a little higher.
And I do think, you know, as I look at the future, clearly our gross margin is where the opportunity is in terms of improving our operating profit and when we've had gross margins in excess of 40% on a reported basis, you know, we've delivered our record -- our record 1999 operating profit of 18%.
So if we can get our gross margins in the 40s and we can maintain our good SG&A performance, then, you know, I could see a higher than 14% operating profit, but at this juncture I prefer to be conservative and, you know, have our goals appropriately conservative, but there is, obviously, the opportunity to do better.
- Analyst
That's what I was trying to get a sense of, if those -- if those trends continue is that peak operating margin something that is reasonable to assume and assuming that your '05 SG&A growth plans are incorporating any expenses associated with the new concept?
- EVP & CFO
Oh, yes.
Well, first of all, you know, we get that question a lot, about 1999, is that still possible and if you look at every retailer in 1999, it was a record year.
- Analyst
Right.
- EVP & CFO
And I can't tell you -- you know, a lot of things have changed, there is more competition, there are other factors involved, but it would only -- you know, if I were to guess, I would say that, you know, with -- you're going to have lower costs related to the reduction of quota, there are benefits that are -- we've seen a lot lower costs and deflation, but, you know, I would have to guess to say that we would get back to 18 and I don't know that that's a sustainable long-term year in, year out goal.
I think that something a little less than that is a more appropriate goal.
- Analyst
Great.
Thank you very much.
- EVP & CFO
Sure.
Operator
Your next question is from the line of Holly Guthrie of Morgan Keegan.
- Analyst
Thank you and congratulations.
Just if you could talk about your promotional calendar this year versus last year.
I know you mentioned in August you didn't anniversary the friends and family, what -- what's coming up for September and October?
- CEO
Well, as we've -- Holly, as we said before, we're really doing much, much less promotional activity, advertising, than last year.
- Analyst
And that's it.
All my other questions have been answered.
Thank you.
Operator
Your next question is from the line of Eric Graves of Pacific Growth Equity.
- Analyst
Hi there.
Eric is my middle name, I would guess.
Congratulations on the quarter.
Any opportunities, now that you're seeing some success in Canada open American Eagle stores, to judiciously expand in some additional countries whether they're contiguous to U.S. or not?
- CEO
Yes.
Actually, we're looking at -- we're looking at some other opportunities but there's nothing really definitive I can say at this particular time.
But we are open and we've had plenty of discussions with -- with certain people who have an interest in the American Eagle brand elsewhere, but right now, we're focusing in on the new concept and also maintaining momentum at American Eagle.
- Analyst
Have you seen credit card files at all, can you see whether in foreign tourist, gateway cities like San Francisco or L.A. or New York, that you have a preponderance of visiting purchases by, you know, say folks from the U.K. or Japan or Australia?
- CEO
The answer is do we use those vehicles, yes.
Do we feel there is a sense of a -- of a brand awareness and a brand acceptance outside the United States, both in Europe and in Asia?
The answer is yes.
To a great degree, I can't really say that, you know, that the brand would automatically resonate, you know, in every part of the world.
It would take some advertising, you know, an intense marketing program, but definitely the brand, I believe, has a great deal of universality built into and a -- and a strong base of consumer acceptance because we see that from where we operate in the United States currently with certain parts of the country having strong components of ethnic groups.
- Analyst
Okay.
Great.
Congratulations.
Thank you.
- CEO
You're welcome.
Operator
Your next question is from the line of Dena Telsey of Bear Stearns.
- Analyst
Good morning, everyone, and congratulations.
- CEO
Thanks, Dana.
- EVP & CFO
Thanks, Dana.
- Analyst
Roger, can you talk about the processing -- the process of merchandising?
It has obviously been greatly improved, floor sets, flow and timing.
Any other adjustments that you're making going forward obviously since you've enhanced the design team also?
And how are you planning holiday merchandising and marketing for men and women?
Thank you.
- Vice Chairman & President
Well, we're pleased with the disciplines that we put back in place and the adjustments that we made to the merchandising process.
As we indicated before, Dana, the big thing was to reduce the number of design lines from 10 down to 6, which didn't change the number of merchandising sets that Susan needs to do for the stores, which still gives us the fresh factor of 10 times a year.
But it makes it much more easily for the design and merchant groups to work together and that focus has really paid off big time.
And the disciplines, quite frankly, throughout the organization that Jim has been very impactful on, and especially on the timing and action calendars for the organization, those disciplines are really working in our favor.
And the teams are working very hard and everybody is enjoying what they're doing.
And I don't want to make any changes to what's working now.
- Analyst
And then two tests that we've noticed in our store towards the customization station, how is that going?
And the larger intimates and beauty sections in the stores, should we see that being expanded further?
- Chief Marketing Officer & EVP of Strategic Planning & E-Commerce
Dana, it is Michael Leedy, we only have customization in a few of our flagship stores.
It is a great program for those stores, it's exciting for the customer but at this point it really isn't anything that we're thinking about expanding.
It's a -- you know, one of the things that's an issue in expanding it is space, but again, we love it for the flagship stores.
And I will let Susan answer the second part of the question.
- EVP & Chief Merchandising Officer
Dana, on the intimates expansion strategy that you're seeing in some locations, we're constantly looking for growth vehicles and avenues of business that, you know, will pave the way for the future for this brand and our success in intimates at the lifestyle extension feels really good to us.
It is great business.
The girl loves it.
It is a highly profitable business.
And what we have going on right now are a couple of side by side locations that we're trying.
And also, some expanded square footage in some of our larger square footage stores to capitalize on, hopefully, more sales productivity.
And in those stores we haven't really reduced any of our other assortments but used that space in a more appropriate, more productive way to expand the intimate apparel and personal care areas.
This is very early in its testing stages.
It just got out with the beginning of back to school.
We are pretty pleased with some early results.
But this is -- we are going to revisit this again on February 1 and decide where to go.
- Analyst
Thank you.
- EVP & Chief Merchandising Officer
Sure.
Operator
Your next question is from the line of Christine Chen of Pacific Growth Equity.
- Analyst
Hi there, congrats on another great quarter.
- CEO
Thank you.
- EVP & CFO
Thank you.
- Analyst
Just wondering, when will we see the next new merchandise flow hit the stores?
- EVP & CFO
You will see our fall floor set, Christie, the week after Labor Day.
- Analyst
The week after Labor Day.
Okay.
Thanks, all my other questions have been answered.
- EVP & CFO
Brandy, I think we have time for one more question.
Operator
Okay.
Your final question is from the line of Todd Slater of Lazard.
- Analyst
Thank you.
And congratulations to the merchant team again.
- CEO
Thanks, Todd.
- Analyst
Also, Jim, your operational success, congrats.
We calculate that your average denim pricing is down about 17% versus last year.
I think that comes out to down about 23% in men's and down about 11% in women but I'm wondering if you could talk about the cost side of the equation, directionally sort of what the IMUs in denim are like this year versus last year.
- EVP & CFO
Todd, I will take.
I don't -- I'm not quite sure how you're getting to your calculations.
I don't know if what you're seeing is a little bit of expansion in the 29.50 price range of our denim, but, as we've talked about, that 29.50 strategy for us makes the denim very accessible but what it also helps us do is trade the customer up to the 39.50 and $48 denim.
We are very pleased with the average unit retail and the balance of our denim business and the costs are very appropriate to those retails.
- Analyst
So are the IMUs or the margin in that business going into the season and into fall, are they -- would say that, you know, similar to last year, up a little versus last year, down?
- EVP & CFO
It was up the quarter at or above last year.
- CEO
Todd, our -- our average unit retail for the second quarter which I can talk to, in denim, was on the men's side was up 20% average unit retail and on the women's side, it was up 5%.
So I don't know where you're getting your number from.
- Analyst
Well, is that -- that's the before your -- any markdowns or anything else?
- CEO
That is after everything.
- Analyst
That is after everything?
- CEO
That's through the cash register.
- Analyst
I'm talking about the starting price.
Obviously, I don't know what your ending, you know, sale price is on everything but I can calculate what we're starting at.
- EVP & CFO
Yeah.
Todd, to add one more thing to that the way that we're positioned right now with value at the opening price and the way that we move up into the assortment, we're doing a lot of regular price business.
The markdown rate is very minimal.
- Analyst
Okay, so in light of that, in light of how well you're tracking in denim, could you discuss a little bit the strategy around the $5 denim sale that started yesterday, how long that will run, how -- what we're anniversaring in that sale?
All that kind of stuff.
- CEO
We believed in order to get the value message out, which we did, as you know, after Christmas as a posture, that we would run the denim promotion, well-planned, well bought for, both in terms of the presentation, the inventory and the costing, for a three-week period for back to school.
Based on how successful the denim business has been in the overall business, we made a decision to only run it for one week to get that message out.
We just don't need to do it.
The business is that strong.
- Analyst
Was that a change from your original plan?
When did you go -- ?
- CEO
The original plan was for three weeks.
We've reduced it to one week.
- Analyst
Okay, so it goes back up in --
- CEO
It is already in the early stores, we took it off after one week.
In the late stores, it is in mode right now, and it will end next week.
- Analyst
Okay.
That's great.
Can I ask one question for Laura?
- EVP & CFO
Sure.
- Analyst
Okay.
I'm all for conservative planning, especially in the teen world, but you've got a two year average comp right now that is trending at about 5%.
You said August was pretty strong.
And I'm just wondering if that suggested sort of a 5 -- that that trend can -- is sustainable, that sort of 5 year -- 5% 2 year comp.
- EVP & CFO
Yes, it is definitely sustainable.
- Analyst
All right.
So you're up against a negative 10% third quarter comp, so that would suggest a 20% comp in the third quarter this year.
Could you talk me down from this type of expectation?
- EVP & CFO
Yeah. [ Laughter ]
- Analyst
Okay.
Given everything you know now, how you can talk me down from that?
- EVP & CFO
We certainly don't plan for that kind of comp performance and when we entered the spring season of this year, we had planned a, you know, a single digit comp, and as you know, we achieved a double digit comp, and we had an even better second quarter than first quarter.
So what we tend to do here is plan conservatively.
We have the inventory to achieve a double digit comp in the third quarter.
But at this time we are not going to give a forecast out.
As I said earlier, it is 11 days into the third quarter.
But we are optimistic and our business is strong and we will give further guidance at the end of the month.
- Analyst
Okay.
Thank you.
- EVP & CFO
Okay?
Thank you.
- Analyst
Good luck.
- EVP & CFO
Jim?
- CEO
Thanks very much, everyone.
- EVP & CFO
We appreciate it.
- Vice Chairman & President
Thanks.
Operator
Thank you for participating in today's American Eagle Outfitters second quarter earnings call.
This concludes today's teleconference.
You may now disconnect.