Abercrombie & Fitch Co (ANF) 2004 Q2 法說會逐字稿

Please stand by.

We're about to begin.

Good day, everyone and welcome to the Abercrombie & Fitch second quarter earning' results teleconference.

Today's conference is being recorded.

If you have a question at any time during today's conference, you may signal us by pressing star, one on your touch-tone phone.

We will open the call to take your questions at the end of the presentation.

At this time I would like to turn the conference over to Mr. Tom Lynnex.

Please go ahead, sir.

Good afternoon and welcome to our second quarter conference call.

After the market closed we e-mailed to your offices the quarterly sales and earnings release, balance sheet, income statement, and an updated financial history.

If you have not received these materials, please call Courtney Depenhart at 614-283-6751 and she will forward them to you.

This call is being taped and can be replayed by dialing 1-888-203-1112.

You will need to reference the conference ID number 302163 to access the replay.

You may also access the replay through the Internet at Abercrombie.com.

With me today are Mike Jeffries our Chairman and Chief Executive Officer, Bob Singer, President and Chief Operating Officer, and Sue Riley, Senior Vice President and Chief Financial Officer.

After Sue reviews our financial results, Bob will comment on the business, and then Mike will discuss the business from a merchandising perspective.

Today's earnings call will be limited in time to one hour.

After our prepared comments we will be available to take your questions for as long as time permits.

Please limit yourself to one question so that we can speak with as many callers as possible.

Before we begin, I remind you that any forward-looking statements we may make today are subject to the Safe Harbor statement found in our SEC filings.

Now to, Sue.

Hi, everybody.

Total sales for the second quarter were $401.3 million, a 13% increase versus last year's second quarter sales of $355.7 million.

Comparable store sales declined 5% for the quarter.

By business, comps were as follows.

In the adult business, Abercrombie & Fitch comp store sales declined 6%, with both men's and women's both negative for the quarter.

In our kid's business, Abercrombie, comps decreased 9% with girls and boys negative.

In Hollister, comps increased 4% compared to last year for the quarter, both girls and guys were positive.

On a regional basis, comps were strongest in the northeast region and weakest in the southwest.

Strongest markets include Florida and New York metropolitan area, the weakest market was Texas.

The gross income rate was 45.2% up 460 basis points from last year's rate of 40.6%.

The increase in the gross income rate resulted primarily from higher initial markup, partially offset by a higher markdown rate.

The improved IMU reflects continued progress in sourcing across all businesses, coupled with higher average unit retail pricing in A & F and kids.

The increased markdown rate reflects our strategy to clear markdown merchandise quickly to enable us to add more items to the selling floor.

We ended the first quarter with inventories down 12% per gross square foot versus last year at cost.

The drop versus last year reflects a number of factors.

First, we planned the business very conservatively this spring.

In addition a portion of the reduction reflects reduced costs in our ending inventory.

Finally, denim has performed extremely well in recent months and although we have increased the merchandising plan compared to last year, the business continues to turn faster than expected.

Our strategy going forward is to continue to manage inventories conservatively and as such, we expect inventory per square foot to be down versus last year at the end of the third quarter as well.

The second quarter SG&A rate was 21.1% of sales, 320 -- 28.1, excuse me, percent of sales, 320 basis points higher than last year's rate of 24.9%.

The increase in rate versus last year, primarily reflects higher store and home office expenses.

Home office expenses include increased payroll and incentive compensation costs, including increased expense related to the retirement of an executive officer.

The increase in store expense as a percentage of sales largely reflects the realization that we need to increase investment in stores largely through store payroll.

Bob will elaborate on that in a moment.

Our distribution center continues to achieve record levels of productivity.

During the second quarter, units processed per labor hour were 15% higher than last year.

This year's increase was on top of the 29% increase last year.

We continue to process more units with fewer labor hours.

Our e-commerce business continues to grow rapidly.

In the second quarter net sales from the Internet increased over 50% versus last year, with strong growth in all three businesses.

Our international e-commerce business continues to grow, reflecting the strength of our brands with customers outside the United States and now accounts for over 30% of our e-commerce business.

From an operational standpoint, we continue to be more efficient at operating the business.

During the second quarter, we reduced expense per order by 22% versus last year.

Overall, operating income increased 24% for the quarter, from $55.6 million to 68.7 million.

Net income increased 23% for the quarter, from 34.8 million to 42.9 million.

Second quarter earnings per share on a fully diluted basis were 44 cents, versus 35 cents last year, an increase of 26%.

We opened one Abercrombie & Fitch store, 20 Hollister stores, one Abercrombie store, and closed one Abercrombie & Fitch store during the quarter.

We ended the quarter with a total of 359 Abercrombie & Fitch stores, 171 Abercrombie stores, and 197 Hollister stores.

During the second half of fiscal 2004, we plan to open approximately seven Abercrombie & Fitch stores, seven Abercrombie stores, and 60 Hollister stores, as well as four stores for our new concept in the coming week.

Total square footage is expected to grow roughly 14% versus 2003.

We continue to be pleased with the sales productivity generated by our new stores.

During the quarter, the new stores in all three concepts opened during the past 12 months averaged 97% of the sales per square foot of the existing store base.

For fiscal 2004, our planned capital expenditures will be between 125 million and 135 million.

The majority of these expenditures are related to new store construction, with the balance being invested in store remodels.

I'd like to finish by discussing our profit expectations for the third quarter of 2004.

Assuming a continuation of the second quarter sales trend, coupled with continued investment in the business, we expect earnings will be similar to last year's third quarter EPS.

I would now like to turn the call over to Bob.

Thank you, Sue.

I would like to begin by saying that I am happy and proud to have joined Abercrombie & Fitch.

In my first weeks here, I have begun to become familiar with the management and staff and I must say that I have found the quality of my colleagues and their passion and devotion to the success of this company and each of its brands to be extraordinary.

I believe we have great opportunities to develop our company sales and profits in the coming years.

In reading the reports of many of you who follow us, I know that we are often fundamentally understood as teen retailers.

I believe that we actually have much more in common with my former company, no names, and its peers in that our main focus is on building, maintaining, and controlling our brands.

These brands are valued by customers because they express a lifestyle to which they aspire.

This is a great strength, because it permits us to build and maintain high margins over the long term.

While we also recognize that it sets a limit to how much we can grow any individual brand.

Therefore, what I find most extraordinary about our company is the ability that Abercrombie & Fitch has demonstrated to drive the company's growth in sales and profits and therefore in value to you, our shareholders, through the development of new successful brands.

This means that we may continue to see comp store sales declines from our more mature brand, as we strive to maintain their aspirational qualities and their high margins, but that we will be able to continue to grow the company profitably through the introduction and development of new brands.

In addition, we have excellent opportunities to grow the business outside the United States.

The international component of our e-commerce business described by Sue, as well as the significant international part of our in store business in major tourist centers like New York, Pala Moana, Miami, Los Angeles, and San Francisco, all are strong indicators that a carefully controlled international expansion of our brand should provide a profitable, long-term growth opportunity.

In order to achieve and maintain the aspirational quality of our brands, we must continue to invest and maintain at high levels the quality of our merchandise, our stores, and our people.

In recent periods, I have seen that we have cut back certain important expenditures.

Now, while I am a strong believer in tight expense management, I also know that it is exaggerated -- if it is exaggerated, it will have a long-term negative impact upon our brand, our ability to serve our customer, and ultimately in our profits.

Consequently, we have moved to increase expenditures to maintain and enhance our stores, and increase the quality and number of our store management and staff.

Depending on our sales performance in the second half, this may have some short-term impact on our operating margin.

However, we are convinced that this investment will be rewarded by excellent returns in the future.

In closing, I would like to say that I look forward to meeting and working with many of you in the coming months and years.

Now, I will turn it over to Mike who will talk about our results in more detail.

Good afternoon.

Overall, I am pleased with our second quarter results.

While our sales trend was weaker than I would have liked, our results reflect strong margin improvement, as well as solid earnings growth.

Importantly, we maintained a non promotional look in store during the quarter.

Although this strategy has negatively impacted comps, we are committed to managing the value of our brands for the long-term health of the business.

We started off the second quarter with solid results in May for each of our businesses, both Abercrombie & Fitch and Hollister posted positive comps with the kid's business flat for the month versus last year.

The May trends continued into June through the third week of the month, before slowing dramatically in the last two weeks of June, with the implementation of summer clearance.

Although normal clearance markdowns were taken to clear summer merchandise, we did not blatantly market a big sales event as we have in years past.

Rather, we were deliberately less promotional in look and markdown rate compared to last June.

Although July's weak performance was attributed to this in part, I'm not satisfied with our results for early back to school selling.

At this point, I believe we can be doing more business in the Abercrombie & Fitch men's and Hollister girl's businesses.

Based on our reads, we are planning to be in a stronger inventory position in the better performing classifications by late August and September as receipts flow in.

By business I am pleased with where we are in men's at Abercrombie & Fitch, although comps were slightly negative for the quarter, initial markup improved significantly as did the markdown rate versus last year.

In tops, woven shirts and polos are driving the business.

In bottoms, denim has been very good and I see additional opportunity as we build inventory in this classification.

Our short business, which has become very developed over the years, has been difficult for the entire season.

In the women's bottoms business, jeans and skirts performed well while shorts were weak throughout the quarter.

In tops, knits performed very well in May and June, weakened significantly with the setting of our back to school floor set in July.

Although sweaters and fleece performed strongly these categories could not offset a weak knit top business during the month.

Hollister performed very well throughout the second quarter.

The business achieved a 4% comp store increase with both guys and girls positive.

I'm particularly pleased with the Hollister guys business, where comps increased by high single digits for the quarter.

The guys business was driven by strength in woven tops, polos, and denim.

In girl's, denim skirts and knit tops were strong.

As I just mentioned I see additional opportunity in girl's denim, as we receive additional deliveries in the coming weeks.

Sales productivity in the Hollister business is over $400 per square foot on a trailing 12-month basis and the productivity of new stores continues to be very close to the average for the business.

Hollister's profitability is virtually equal to that of the overall business and the brand continues to increase its relevance with high school guys and girls.

We recently reached an agreement with Surf City USA to feed live video content from the Huntington Beach pier into a number of stores.

I couldn't be more pleased with where we are with Hollister.

We remain very confident with Hollister's prospects for the second half of this year, and beyond.

Trends in the kid's business during the second quarter were similar to the adult business.

In boy's, jeans and polos, performed well, however, the absence of a woven shirt trend compared with the A&F men's business has made boy's more difficult from a comp standpoint.

In girl's denim purchased performed very well as did sweaters and fleece.

Going forward I see additional opportunity as we build inventory in these classifications.

From a marketing standpoint, we continue to make solid progress with new initiatives.

During the second quarter, we introduced our newest part of the Abercrombie & Fitch assortment Ezra Fitch.

At this point Ezra Fitch denim is in all stores and we will add new items as we update the back to school assortment.

As you may have seen last month we launched the first A&F magazine in New York with great success.

A&F magazine which consists of our rising star campaign features young up and coming talented leaders wearing Ezra Fitch.

A&F rising stars are included in our store visual presentation as well as through a national advertising campaign and billboard program.

On our last quarterly call I briefly discussed the timing for the opening of the first stores for our newest concept.

I'm pleased to say we will open our first store by the end of August with three more opening shortly thereafter.

Our Fitch store is scheduled to open in early 2005.

As I look at the balance of this year I feel very good about the strength of our brands.

Despite challenges from a comp standpoint we continue to run a very high margin, well controlled business.

Going forward we will continue to focus on maintaining our position as the leading life style branded business.

Now, we are able to take your questions.

Thank you.

Today's question-and-answer session will be conducted electronically.

If you would like to ask a question, please do so by pressing the star key followed by the digit one on your touch-tone telephone.

If you are using a speaker phone, please make sure your mute function is turned off to allow the signal to reach our equipment.

Today's call has been limited to one hour total.

As such, participants will be limited to one question per person.

For additional questions, participates will need to re-enter the queue by pressing star, one.

We will take as many questions as time permits.

Once again, star, one for questions and we'll pause a moment to gather our roster.

We'll go first to Jeff Klinefelter with Piper Jaffray.

Please go ahead.

Yes, my question for you, on the Ezra Fitch, the higher price points, make up overall, your tone about, you know, going to a higher, more almost like luxury positioning with the customer, and an older customer, you know, it makes sense in terms of what is going on with some of the higher end department store brands out there right now, but, you know, in terms of like not having enough denim right now in the store, it seems like it's missing a great opportunity to actually connect with that customer while they're out after a new product category, an aspirational product category.

How do you market to or reach that customer in the meantime?

I'm sorry, Jeff.

I'm little confused by the question because the Ezra brand is not targeted to an older customer.

It is targeted to the same Abercrombie & Fitch customer, 18 to 22, and we are selling that product in all stores at this point.

You are correct that we need more denim in the Abercrombie & Fitch men's business and the Hollister girl's business, and we are working very, very hard to build that inventory.

I know you've been in the stores and you can see how fast we're turning out of it.

You are right, we are missing business there.

We will take our next question from Jennifer Black with Jennifer Black Associates.

Please go ahead.

Good afternoon.

Hi, Jennifer.

Hey, hey, I had a question.

I had heard that you had switched to vendors in Mexico, and I had heard some of the vendors, I mean that you guys were -- I know how cheap you can be as far as your sourcing, because you control costs, but I wanted to know why you made that change, where you are in your sourcing, and if you are at a point where you can't get any more sourcing efficiencies.

Okay.

That's a good question.

But to start the conversation, we look for two things as we add to our vendor base, and that's quality -- maybe three things, quality, consistency, and then price.

But the quality and consistency are more important to us than price.

We're sourcing from a worldwide factory base.

And that really hasn't changed.

There is probably more denim coming from Mexico than has -- than has come from Mexico in the past.

That's just because there are quality factories available there, and we're not really -- there is not a lot of switching going on.

We're adding to our capacity.

And I think that our sourcing department has really done a terrific job in fulfilling all of our needs, the quality, consistency, and price.

We wish we had a lot more denim at this point.

And we are working on it very hard.

We will go next to Margaret Mager with Goldman Sachs.

Please go ahead.

Hi, Margaret Mager.

Can I ask about the new store productivity where you mentioned that you're running your new stores at 97% of the existing store base?

What has been the trend in that number over time?

Has it come -- is it getting --

It has been consistent.

I think it's rising.

It's rising a bit.

As it has to as the store base changes.

We used to be at 90.

Although it is moving north.

It has been fairly consistent.

That's a good question, but it is greater than it has been in the past.

We will go next to Richard Baum with Credit Suisse First Boston.

Please go ahead.

Good afternoon, everybody.

Hi, Richard.

This is a question I guess for Mike or Bob.

This is really the first time that we have heard any conversation about the necessity to increase expenses in the store, in order to either drive sales or protect the brand.

I'm wondering what, you know, what is behind this decision to do that, and can you also give us some indication of where the expenses, you know, where you -- where you expect to spend more money and directionally, how much more you are expecting to spend in the stores.

I think that the additional expense is fundamentally, people, although there are other aspects in terms of just maintaining a high level architecturally, and image in the store.

An example is we just changed all the lights in the A&F stores.

We have been painting.

You probably have seen, we have been painting the stores gray.

Or we have been putting in the Hollister screens with the feed from the Huntington pier that Mike mentioned.

These are all things that do add a certain amount of expense but are obviously, we think, going to enhance the image and the quality of the stores and environment to attract people in.

And we will continue to do this.

In terms of the people, we think that by having better coverage of the floor, by having better coverage, also, within the store, to continue to fill the tables, and the other displays, to make sure that we have size integrity, we've introduced a program, a very systemic program to enable the store managers and the people in the store to do a better job of making sure the stores are, we say, perfect.

That's the objective.

And in order to do that, we have to give the store managers enough staff time to be able to do it.

We can't expect them to accomplish that otherwise.

So Richard, I think just -- just for my input, we realize that we can do a better job out there.

We've instituted a ton of programs.

And they don't come for nothing.

We will go next to Dorothy Lakner with CIBC World Markets.

Please go ahead.

Thanks.

Good afternoon, everyone.

Hi, Dorothy.

Bob, could you add a little bit more color to the comments on adding -- adding store payroll?

I mean what exactly are we talking about in terms of people in the stores, and over what period of time can we expect to see this -- this happen?

And then I also just wanted to ask if you could give a little bit of color on -- I don't know, a time frame for international growth which you brought up, and finally, a question for -- for Mike, if you could sort of compare the new concept, if you would, with A&F, given the higher price points of the Ezra Fitch brand, I just wondered where the new concept is going to shake out in terms of the price points to be expected.

Thanks.

Dorothy, we have to enforce our one question rule or everybody else will get upset with us, but I think just in terms of the people in the stores, it will start to happen in the fall, and we're going to do it if an intelligent and thoughtful way.

We're not going to just -- we're not just throwing people or hours at the stores.

We're going to -- we're thinking through where they should be.

But the issues we're dealing with are things like front room coverage and making sure that they are making sure that people are greeted when they come into the store.

Fitting room coverage is another area.

And quite honestly, what we hope is that we're going to see real benefits in the way of sales and say, reduced shrink that will enable us to pay for most of it.

So we're hopeful that this is not going to be a major damper of profitability.

And in terms of international, I mean obviously, as you know, I come from an international background and I think that this is an area that there is a great opportunity, and we're going to start it slowly and I don't want people to get overexcited.

It's not going -- we're not going to go out and do massive international campaign right now, but we're going to move country by country, and think about where we should be, and do it in a very controlled way.

What I found here is a situation of perfect control.

This brand is totally controlled by this company.

I don't know any other brand in the world that has that characteristic.

And I think that is why it is so appealing.

And it appealing outside of the United States to people.

I think we have to preserve that, and roll it out in a way that we are able to preserve that.

Thanks, Dorothy.

We'll take our next question from Michael Dowahare with Jefferies.

Please go ahead.

Good afternoon, everyone.

My question is a merchandising question.

In February, we were told of strategic initiatives that would, you know, reflect more top line and we were kind of given a back to school as the time to look for these things, and if I'm hearing you correctly, the women's knit business is not performing in July, and that would be, you know, probably one of the most important classes that any back to school merchandising team would have to get right.

Where was the breakdown in women's knits and how does that jive with a new team who was supposed to kind of take the business to the next level this back to school?

The answer to that is we are doing everything we can.

There is a weakness in that business that we are working hard to correct.

Fortunately, that business has shorter lead times than many, so we are working on correcting it.

The sweater and fleece business is excellent.

We're building those inventories.

It's a moving target.

We hope that that business will improve.

We're working very hard to do so.

We will take our next question from Joe Teklits with Wachovia Securities.

Please go ahead.

Thanks much.

Hi, guys.

Hey.

Mike, at the beginning of the year, you talked about the strategy for this year of driving sales, and many of your efforts would be toward driving -- driving sales volumes higher, and now hearing Bob speak about the strategy, I think it primarily relates to the Abercrombie & Fitch adult store.

Has your mission now for this this year, even in the second half of the year, changed?

Or can you combine driving sales with being aspirational, et cetera?

And what's your -- and it is the same question, so I don't think it is two questions.

And in your release, you say assuming comps continue at the second quarter pace, you know, what kind of clarity do you have on that in regard to these missions as well?

Okay.

I -- the statement assuming comps continues is a conservative statement.

We're working very hard to improve that trend.

We are working at the top line, but we are working at the top line from a quality perspective.

We're working on improving the top line in terms of better quality, better assortment, better flow of merchandise, and we're not doing it with a promotional stance.

It's very difficult, Joe, to see where that shakes out.

I look at it by classification.

I think we're doing everything we can to grow the business in a quality way.

I think we will.

I think we have to get over anniversarying some of these promotional events.

We certainly were up against virtually liquidating inventory last -- at the end of last June and July.

I think that fourth quarter, because it was a difficult quarter for us, we were more promotional than we wanted to be.

We had direct mail which we will not have this year.

I cannot tell you exactly where that is going to shake out.

I really can't.

But I can tell that you we are building a quality business.

And that's what we're here for.

The quality to extend into the future.

And I will tell you that as of the end of this year, we are not up against anything but -- anything that we're proud of in terms of how we're growing that business.

And I think there is consistency there.

I just can't predict accurately what is going to happen on a comp basis in a month by month basis.

We will go next to Rob Wilson with Tiburon Research.

Please go ahead.

Yes.

Mike you can address your friends over at American Eagle and the success they're having this back to school season and maybe why some of the differences in your product versus American Eagle?

I'd rather not get into that conversation.

You know, I'm not here to evaluate other people's assortments.

I think it's -- they're on one track and we're on an entirely different track.

And we're here, as I've said, many, many times, to enhance the quality of our brands, which we are doing weekly, and to enhance our bottom line.

That's how we look at the business.

And I think that is what we're doing.

They have a different strategy.

We will go next to Kimberly Greenberger with Smith Barney.

Please go ahead.

Thank you, good afternoon.

I have a question on inventory management, Mike.

Have you given any thought to trying to identify the best sellers ahead of when, you know, you're placing those orders so that you can distort inventory in those items in an effort to drive the stop line growth?

I think that's a good question, Kimberly.

Yes, we do.

We're working hard at doing that.

And I think that as trends become stronger, it's easier to do.

We're working very hard on that on -- for the fourth quarter, where we recognize that our assortments have to be narrower than during the rest of the year, and we have to get behind key items more aggressively than we do the other third quarters.

But that's a very good question.

We will go next to Josh Schwartz with Flatbush Water Mill.

Please go ahead.

Good afternoon.

Hey, Josh.

How are you?

Good.

I'm going to try to -- I'm going to stick to my one question so I'm trying to figure out the best way to ask it so you give me the real answer I'm looking for, but the real question is, I guess to Bob and Sue, and, you know, which is -- because you guys I think are new, and I've spoken to you, but I'm curious what your perspective is, it's really I'm looking at the business, if you take away the cash, the company has generated $2.45 in free cash flow in the last 12 months, you control every aspect, like you've said, you have a very good understanding of, you know, what's in inventory, so I think you have a better sense of what your cash flow will be, you know, in a reasonably bad case.

So I want to know if there is any good reason why this company should be holding $6 a share when we can buy the company at 11 times right now?

Well, I mean we did just announce a stock buyback program.

So it doesn't address all of the needs that, you know, that you're articulating, and I think we've mentioned also that we will be making investments, you know, in the business, that we expect to yield a longer term return.

But we did just announce a stock buyback program that we expect to implement over the next 18 months.

I think it is clear to us that there is a base level of cash that we feel we should hold as a -- as a support for the business.

It gives us strength and flexibility in respect of the market, and our competitors, and also to react to any circumstances or opportunities that come our way.

Having said that, we also are very clear that we're continuing and we expect to continue to generate excess free cash and as Sue was saying, we are sensitive to the opportunity to give some of that money back to the shareholders, as part of their return, and we will continue to do that.

Thanks, Josh.

We will go next to Lauren Levitan with SG Cowen.

Please go ahead.

Thanks, good afternoon.

Mike, I'm wondering if you could comment at all on what, if any, market research has been done to get a sense of how your customers feel about the service levels, how they feel about some of the higher price point that have been introduced, and the reduction of the promotional activity?

What I'm trying to get a sense of is, are you certain that your target market, as you elevated the aspirational qualities of the brand, are you certain that the target market is large enough and that the store base that you currently have within adult Abercrombie is the right store base size relative to the business that you're trying to address with this higher level positioning?

Thanks.

Lauren, I think that's a terrific question.

And we look at it two ways.

One, we do do research.

We're conducting focus groups constantly.

We have a branch of the business that just is involved with talking to our customers.

But two, we can look at the results by store category.

Because you would be suggesting that we would be having a more -- a more difficult time in our lower level stores.

In fact, we've worked on programs to inventory those stores better, and they are performing at or better than the chain's rate.

It is something that we will continue to look at very, very seriously, very hard on an ongoing basis.

But I think it's a -- it's a valid question.

I think -- I think that the store base -- I really can't comment on that right now but I think that it is not appreciably inflated in an area where we can't do business.

It might be to some extent and we will look at it.

If I can just add, the Abercrombie & Fitch stores, notwithstanding the decreases in comp sales that we've had for the last couple of years, are all making money.

It's very important to understand that.

And when we think about what the store base should be, we have to think about the aspirational quality and whether there are locations we shouldn't be, but the fact is, they are all continuing to be profitable stores.

Thanks, Lauren.

We will take our next question from Eliot Laurence from Jefferies Asset Management.

Please go ahead.

Thanks.

Good afternoon.

I would like to pick up again on this merchandise issue.

I'm concerned we head into the back to school and we've -- we have had time to evaluate some of the issues in terms of merchandise execution, from last year and earlier this year, and we gather the forces at the beginning of this year and say all right, back to school, you know, watch us execute, and it seems to me that on the knit side, we don't have any key item programs on the knit side, which are tremendously important at that time of the year, and we don't quite have our inventories on denim correct.

And so while I hear everyone say in the industry how beautifully designed the product is, it seems like there has been some disconnect between product design and merchandise execution at the store level.

Well, I think that I have said very clearly that we need more denim, and that's obvious, and we're working on that, and I think that we are working to twist the knit business to what is working.

I just have to say there are key items in the knit business, probably not enough of them at this point.

But I think we are going in the right direction there.

Thanks for your question.

We will go next to Stacy Pak with Prudential Equity.

Please go ahead.

Thanks.

Hey, Stacy.

Hey.

My one question is about guidance.

And I was wondering if you could tell us what the impact to SG&A was from starting up this new division, you know, if there was any in Q2, also 3 and 4, and then starting up, whether the payroll, you know, what's the impact to SG&A there in Q3 and 4, and I'm talking basis points or dollars, not number of people in the store, and then also, on the number/guidance, have you seen any improvement from the last week of July which had to be pretty atrocious in trend?

Okay, first, the first part of your question was the new concept impact on SG&A in the second quarter, and really, there wasn't -- the impact to SG&A was de minimus.

The real increase in SG&A in the second quarter were the three things we mentioned in the call.

We had an executive retirement, we had higher incentive compensation, and store payroll hours, which were a little higher, by -- it's about 100 basis points each, as you look at the basis points increase in SG&A.

And our guidance for third quarter in terms of the store investments that we're making, or basically what we're saying is that we would expect to see SG&A increase somewhat in the are third and fourth quarters as a result of that.

So we're just being somewhat cautious in terms of the SG&A that we're planning for the latter part of the year, knowing that we'll make those investments and that the return on investment might not be immediate.

Okay?

I think we don't give guidance on comps, Stacy, but clearly, the last week of July was really bad, because we are up against the switch of a lot of tax-free states, so clearly everybody would assume that we would state that that rends improved.

We'll go next to Barbara Wyckoff with Buckingham Research.

Please go ahead.

Hi, everyone.

Can you hear me?

Sure.

Hi.

Can you talk a little bit about the trends in gross margin?

You had huge increases first and second quarter.

Given the flat guidance for third quarter earnings, could we assume that most of the savings on costs -- the cost side have been realized at this point?

And that the biggest opportunity on the sell side, and that we should expect, you know, sort of less robust increases in the second half?

Okay.

I will take that one.

Unlike the first quarter where we saw a fairly significant increase in gross margin resulting from IMU that was largely cost -- forcing base because our cost of product was significantly down in the first quarter versus the first quarter of the previous year.

In the second quarter, the gross margin improvement was three-fold.

First, we had the Magalog in last year and this year, we just had a catalog that we've mailed out, at significantly less cost, and that was about -- that is worth about 100 basis points.

Second, in the second quarter, unlike the first quarter, we had about a 200 basis point gross margin improvement, resulting from increases in average unit retail pricing.

And that's a fairly significant change versus the first quarter.

And then lastly, the cost component of the gross margin was about 100 basis points.

So you can see the cost component of margin as we predicted narrowing somewhat, and we expect that to continue through the rest of the year.

And also recall, as we've said, that we saw some fairly significant gross margin improvements throughout last year, particularly in the third and fourth quarters, so we're starting to lapse some quarters where we've already seen improvement.

As a result, we're being somewhat cautious as we project out gross margin for the rest of the year.

Okay?

Thank you.

We will go next to Dana Cohen with Banc of America Securities.

Please go ahead.

Hi, guys.

Hi, Dana.

Mike, maybe just stepping back and thinking about the merchandising issues, you know, inventories were supposed to be up a little bit more here, just looking back at my notes from the first quarter.

Right.

You made a lot of changes in sort of the organization.

I mean is -- maybe there is -- is it possible there is, you know, when you look back at sort of the magnitude of the sort of changes you've made in merchandising at the beginning of the year, that that maybe was a little more than the organization could bear?

Perhaps.

I -- I -- it's a tough question to answer, Dana.

I think that -- well, there are two parts to that question.

One, inventory levels, which -- and I've told that you we absolutely wish we had more denim, but I don't think that has to do with the merchandising organization, truthfully.

And I think we're tracking in the rest of the business with the changes that we made.

We're making solid progress regardless of the look at the comps right now.

It's -- we have -- we're turning our inventories well.

And we're -- and we're making a lot more money than last year in the right way.

So I'm -- I guess I can't express strongly enough to all of you out there, and maybe this is my chance to do so, how very much on track I think we are as a company strategically at this point.

I think the lines are all going in the same direction.

And we're building hugely powerful brands for each age group that we're going after.

And over some period of time, you guys are going to look at us and say, wow, those people control the aspirational business from 7 to 30 and maybe it will be older than that, and maybe there is some cannibalization and whatever, but it is the highest margin, high productivity, highest profitable apparel business that exists.

And you don't get there overnight.

But what what we're doing right now is putting in place all the things that we need to do to get there.

And that's our goal.

And it's not how is August, how is the beginning of September.

It's where we're going.

And we're going there in a very well-reasoned, direct way.

So stay tuned.

We will go next to Christine Chen with Pacific Growth Equities.

Please go ahead.

Hi.

I was wondering why you're assuming that you're going to continue to have negative same store sales trends for back to school if, you know, we think the inventory looks great, you know, the styles look great, but you're being conservative and I guess if there is an upside to what you're guiding, what's the sensitivity to earnings?

We're not giving guidance on comps.

All we're trying to do is equate potential earnings to the sales trend that you've seen.

We've never given guidance on comps and we're not doing so now.

It's a conservative statement to say what's the downside.

That's all.

And we gave you a parameter so that you can do your -- you can do your own thinking about where we're going to end up.

That we feel -- you know, that's a necessary thing for us to do but we don't want to go beyond that.

We want you to think about how you see the business.

Through your calculations.

We're going next to Dana Telsey with Bear Stearns.

Please go ahead.

Hi.

Hi, Dana.

How are you?

Good.

How are you?

Good.

In managing the business for profit, as you look at maybe with the more mature Abercrombie business as you're growing Hollister and potential new concepts to come about, how do you evaluate the growth potential of the business and where do you see the growth rate of the business, whether it's operating margin or sales and earnings growth?

How do you look at it?

One area that I think -- I think Dana that probably in terms of opening new stores in the United States, for Abercrombie & Fitch, we don't really have that much of an opportunity, subject to some very special one-off situations.

I do think there is a fair amount of opportunity outside the country.

I mean the most obvious thing -- we don't even have a store in Canada.

There are obviously cities in Canada like Toronto, Vancouver, Calgary, Edmonton, Montreal, where Abercrombie & Fitch and later Hollister can do business.

And we're starting to look at that.

And I think that beyond that, we have -- we've got a phenomenally successful store in Alamowana, which like all the other businesses who operate there, is 95% minimum Japanese and Asian business and that's a very strong indicator that we can do serious business in Asia.

We have a store in the sea port in New York which is primarily European tourist, and that's another strong indication.

So I think there really is growth opportunity there.

But I want to be very clear.

I don't want -- I don't believe that we just should go and start opening massive number of stores.

I think we have to do in this in a very controlled way.

Because it's precisely because we're controlled the way we are that these people are reacting to our brand in a way that's different from from the way that they react to other brands that a lot of people would consider to be our direct competitors.

Good question.

We're going next to Mark Friedman with Merrill Lynch.

Please go ahead.

Thank you.

Good afternoon everybody.

Hi, Mark.

Mike, can you talk a little bit about Hollister because the focus seems to be on Abercrombie.

First question.

Well, it's a little bit more of a promotional driven brand.

It feels like, you know, obviously why it has got a strong position, I was working in the marketplace, where the opportunities are there, clearly, it's much more differentiated in the fact that it -- you haven't taken it as less promotional as Abercrombie, and what changes, and I was curious from Bob's perspective, also, how he thought there were opportunities for Hollister since it's still a significantly smaller business.

Well, let me just comment on the not -- on more promotional.

It's really not.

It's -- it is just -- it just operates at a lower price point, Mark.

And Mark Friedman who is the first customer of Hollister in the world, should --

You're right, Mike, sorry.

I meant lower price point.

I didn't mean more promotional.

Right.

Okay.

But i is we work very hard to make that brand the most aspirational brand for 14 to 18-year-olds and you can't do that by being promotional.

So we go through the same discipline in Hollister as we do A&F in terms of how we clear goods, how often, and what the promotional posture is in the business.

We have a concept that's (INAUDIBLE) that you know about that offers some little discount for being a part of it, but I don't think that is driving that part of the business at all.

And we're even reconsidering that in terms of putting those moneys into more aspirational events, such as the Coral lands (ph) 22 concerts.

So it's not a different business.

It's just a business that's targeted to a different age, with a lower average AUR.

Bob could address what he sees as the potential of that business.

Well, I think that it is very important -- what I find extraordinary about the company, and its growth opportunities, is what Hollister has become, starting from basically a nonexistent basis 32 years ago.

And applying exactly the same values as Abercrombie & Fitch to a different market, but using exactly the same kinds of tools, and you see this, if you go into the store, you -- we're getting a response from that customer, which is extraordinary, and there are many locations where we can open stores, and we can do a lot of additional business.

This is going to be clearly the main growth driver of the company going forward in the next couple of years.

And I think that the new concept that we'll be launching, again within its own world, which you all still have to see, will also become a growth driver.

And I think this is the most important thing.

And I tried to say this in the opening remarks.

The ability of this company to create brands like that and to create environments where people can shop in products that people want to buy is an extraordinary ability, and this is where the real growth of this company will come from and I think we have great, great potential there.

Thanks, Mark.

We will go next to Janet Klockenberg with JJK research.

Hi, guys.

Hi, Janet.

Great quarter.

I'm a little confused about the inventory levels and the direction of inventory.

I heard Sue say that you would be managing inventories more conservatively going forward.

And Michael, I listened to you talk about the inadequate levels of I believe you said denim as well as some men's inventories.

It's denim in Abercrombie & Fitch men's and Hollister girls.

Hollister girls.

Abercrombie & Fitch men's and denim overall.

And so I'm wondering, what we should expect of inventory levels given that Sue said one thing and Mike, to me, said something different and if the direction is to raise overall inventory levels, if you feel that will be a catalyst for comp store sales growth going forward.

Okay.

Good question but I don't think that's a catalyst for sales growth go forward.

I think that we would be -- we are not to the planned inventory levels in denim as of this moment.

If we got to those we would not be missing business.

We will continue to tightly -- and that will happen within a matter of weeks.

But we will tightly control the inventories.

Which means that the end of the third quarter, we'll be down to last year, but I believe there will be significant inventory to drive -- to maximize the business at those levels.

I think it's a different mater from where we are right now.

And you and anybody can go into a store and see that we are just turning those inventories too quickly.

But we are below what we should be in terms of the plan.

Does that make sense?

Thanks, Janet.

We will go next to Larry Schnermocker with Oppenheimer and Company.

Please go ahead.

Yeah, you guys announced the buyback on the 29.

Was that at all in anticipation of today's announcement guiding forward?

No, it's because it was discussed with the board of directors and having -- had the approval of the board of directors, we followed the legal requirements that we make a prompt announcement.

Further, that was really a continuation of the buyback program that we concluded in the first quarter.

So -- and a function of our ability, you know, that Bob talked about earlier, our cash generation, which we -- which remains very strong, so we would like to have ongoing buyback programs in place.

We'l go next to Brian Tunick with J.P. Morgan.

Thanks.

Good afternoon.

I guess my question is for Bob.

It sounds like you really don't think the marketplace, you know, really understands who the Abercrombie & Fitch adult stores competitors here.

I guess we're all confusing it with, you know, Arrow and Eagle and Paxson.

So I would be curious from your, I guess, fresher perspective, you know, who is the adult Abercrombie & Fitch competing with in your view, and you know, who may be taking share from them?

Well, it's an interesting question.

I mean I -- you're asking me, and I think, you know, Mike is probably better qualified -- certainly better qualified than I to respond, but I don't see it as a question of who we are competing with.

I think it's a question of what we're trying to be.

And there is a customer who wants to identify with that.

And I think that's what we have to try to do.

I don't think we're trying to take business away from somebody else.

I think we're trying to be what we should be and then that that customer who identifies with that, and that's true at Abercrombie & Fitch, it's true in Hollister, it's going to be true in the new concept, and that's what I found here, and that's the essence of being a brand company, in my experience, as opposed to being a retailer.

And it's exactly the same thing that we used to say in the company that I used to work for, no names, and it's principal peer companies, and they all have this in common, of maintaining a high level of control, and making an environment and a lifestyle and an image and a product that their customers' going to identify with.

And that's what is here.

And that's why I came here.

Because that's exactly the spirit that I found here.

And I think that -- I think that's exactly right.

This is Mike.

And I think the question that was posed before, is there a large enough market to support where you are, where you're going, and the answer is absolutely yes, because it has created the most profitable apparel specialty business, and that customer continues to make us more profitable.

We sell goods at astounding margins and we'll continue to do so.

We'll take our next question from Howard Tubin with Cathay Financial.

Please go ahead.

Thanks very much.

Just one more question on gross margin.

Is it fair to say that going forward, the improvements that we saw in the second quarter are related to the higher average in retails around the savings related to the catalog -- are those sustainable on a going-forward basis?

Yeah.

Yes they are?

Okay.

Yes.

Okay that's it.

Thank you very much.

Okay.

We'll go next to Bert Buckay with Berm Equity.

Please go ahead.

Hello, guys.

Again, a question on gross margins.

Down at the first quarter after that 320 basis points improvement, you kind of signaled to us that we wouldn't -- we will be surprised to get that time frame, and now you're coming out with -- for under 60 basis points and we infer from it if I take out that one-time 100 basis points on the severance charge, that will add another 3 cents to your earnings, so it's again a phenomenal quarter.

Obviously, I do understand the new investment that you talked about, but I'm really troubled with your guidance of 52 cents.

Can you shed more light on that?

Sure.

Firstly, the 52 cents related directly -- we didn't give guidance of 52 cents.

We tried to equate earnings with sales, at an investment level that we think is appropriate for the long-term health of the business.

In terms of the gross margin guidance that we gave, you're right.

First quarter margin was very strong.

I think when we had said we didn't expect it to -- we didn't expect that level of margin improvement throughout the year, we were referring to the second half of the year, not the second quarter per se.

So I apologize if there was some confusion on that but it was in fact directed toward the latter part of the year.

And again, if you look at the margin progression, through the latter part of last year, you really saw some significant improvement in the third and fourth quarter.

So again, we expect our margins to be strong but we don't expect to see the same level of margin increase in the third and fourth quarters like the gross margin that we saw in the first and second quarters.

With regard to SG&A, as I said earlier, we simply are projecting a level of investment that we think is appropriate for the business.

And equating earnings to a sales level.

Okay?

We will go next to Brian Rounic with BLR Capital Partners.

Please go ahead.

Hi, how are you doing?

I would like Michael Jeffries to please give a little more clarity with reference to your view of the business, because what I'm hearing you say is that you feel really good about where the business is and where it's heading, but I think that most of the people on this call, as well as myself, are looking at the gross margins in the back half and saying geez, these guys have maxed out their gross margins, their comp store sales trends are terrible, their inventory levels that were probably supposed to be a little bit more aggressive heading into the back to school season are nonexistent, they're missing on key categories in back to school but Michael I hear you saying that you're happy with the business going forward.

So my question is is can you just clarify what you're looking at that the numbers aren't showing.

Sure.

What I'm saying to you is that I think strategically we're positioning this business exactly where it needs to be, that we are running a quality business, we are generally where we need to be in terms of classification by merchandise.

We are a little under inventories in a few classifications.

Which is remediable.

We are tracking with our mission, which is improve the quality level of this brand, to secure these brands, to secure our position, as the aspirational brands for each of our age groups, and to maximize profit while we're doing it.

I think we're very much on mission in that regard.

And I am not one bit upset about -- or thinking that we are off track in any of these areas.

And if I could just add one more point, and I think, you know, the point that was made before by Mark Friedman, the growth engine of this company is not the Abercrombie & Fitch brand.

The Abercrombie & Fitch brand is to maintain its level and continue to generate very good margins.

The real growth engine right now is Hollister.

And we -- we've opened many stores, you've seen how many stores are already opened compared to last year.

We have on plan to open another 65 stores this fall.

And to use the word terrible about the results of this company, I think is a terrible misnomer, quite honestly.

Thank you.

This does conclude today's question-and-answer session.

I would like to turn the conference back to your speakers for any additional or closing remarks.

Thank you for calling.

Thanks, everybody.

Bye.

Ladies and gentlemen, this concludes today's teleconference.

We thank you you for your participation.

And you may disconnect at this time.