Burlington Stores Inc (BURL) 2014 Q2 法說會逐字稿

Greetings, and welcome to the Burlington Stores, Inc. second-quarter FY14 earnings conference call.

(Operator Instructions)

As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Bob LaPenta, Treasurer at Burlington Stores Inc. Thank you. You may begin.

Thank you, operator. Good morning. We appreciate everyone's participation in today's conference call to discuss Burlington's second-quarter FY14 operating results. Our presenters today are Tom Kingsbury, our Chairman and Chief Executive Officer, and Todd Weyhrich, our Chief Financial Officer.

Tom will begin with a brief overview of the quarter's financial results, and update you on the progress we made toward the goals we outlined during our IPO. Todd will then review our financial results and future outlook in more detail before we open the call for questions. Before I turn the call over to Tom, I would like to inform listeners that this call may not be transcribed, recorded, or broadcast without our express permission. A replay of the call will be available for seven days.

Also, remarks made on this call concerning future expectations, events, strategies, objectives, trends, or projected financial results are forward-looking statements, and are subject to certain risks and uncertainties. Actual results or events may differ materially from those that are projected in such forward-looking statements. Such risks and uncertainties include those that are described in the Company's S-1 and in our other filings with the SEC, all of which are expressly incorporated herein by reference.

Now, let me turn it over to Tom.

Thank you, Bob, and good morning, everyone. I am delighted to share with you another quarter of strong results that included significant progress toward our long-term goals. Once again, we performed at a very high level. Our top and bottom lines exceeded our guidance, and even more gratifying is that we surpassed the increased comp sale guidance we provided in mid-July.

We believe our consistent strength demonstrates the improved execution of our off-price model and the successful implementation of our growth strategies by our team. We continue to believe we are in the early stages of realizing the full benefits of our operating model, with considerable runway ahead on our growth initiatives, thus position us well for the second half of the year and the longer term.

Let me share with you some specific highlights of the second quarter. We reported strong sales momentum, with total sales rising 8.3%. Comparable-store sales rose 4.7%, on top of a 7.8% increase in the second quarter last year. This represents our sixth consecutive quarter of positive comp sales. In addition, we have reported comp-sale increases in 15 of the last 18 quarters.

Gross margin expanded. We leveraged our SG&A, and adjusted EBITDA grew $11.2 million, or 24%, from the second quarter last year. We had a net loss per share of $0.01, a significant improvement from a loss per share of $0.19 last year.

In addition, we are pleased to report the following accomplishments during, and subsequent to, quarter end. Comparable-store inventory decreased by 18%, contributing to a 22% faster comparable-store inventory turnover during the quarter. We continued our store expansion, and we entered the third quarter with a much more current inventory position and significant open-to-buy liquidity to take advantage of the great buying opportunities we see in the marketplace.

We increased our financial flexibility and reduced interest expense going forward through the refinancing of our debt that was completed on August 13. Later, Todd will take you through the details of our financial performance and our 2014 full-year and third-quarter guidance.

Fueling our comp-store sales increase were strong performances in key businesses that cater to our core female customer, such as missy sportswear, dresses and suits, accessories, and ladies shoes. In addition, our men's, kids and athletic shoes, men's, and home businesses all performed to Company average.

We were able to achieve these results with improved execution of our off-price model. This includes having substantial liquidity to take advantage of the great in-season buying opportunities, continuing to expand our vendor and brand base, and improving our merchandise localization. All regions delivered positive comps, with the Northeast and West outperforming our reported comp, and the Midwest and the Southeast below.

The continued growth in the quality and quantity of our vendor base has helped fuel this strong performance. We continue to increase our better and best receipt unit penetration, as well as our branded receipt units. Traffic and AUR were essentially flat for the quarter.

Our 4.7% comp was driven by higher transactions based on increased conversion rates and a higher average basket based on more units per transaction. We believe the increase in conversion rates was not only driven by better assortments, but also by our continued improvement in the in-store experience. We remain focused on simplified merchandising, clear navigational signage, size fixtures, well-organized selling floors, and a better alignment of our selling hours to customer traffic, which all translate into a better customer experience.

I'd like to provide an update on a few other initiatives that positively impacted all of our regions and categories. We continue to make progress in terms of tailoring our assortments across brands, lifestyles, sizes, and climate. For example, we improved the timing of our seasonal product deliveries by region, allowing us to get the right product to the right locations at the right time. This contributed to a significant reduction in spring seasonal product ownership at the end of the quarter. We are looking forward to the continued benefits localization will have on our results.

Inventory management continues to be an important initiative in driving comp performance, and we continued to make great strides on this front during the quarter. We are very pleased with the level and currency of our inventories at the end of the second quarter, as our comparable-store inventory level decreased 18% versus last year, with our comparable-store inventory turnover improving by 22%. In addition, the level of aged inventory decreased significantly versus last year. All of these metrics have helped us in improving the freshness on our selling floors, which we are focused on providing to our customers every day.

At the end of the quarter, pack-and-hold inventory represented 28% of our total inventory versus 21% last year. As we have stated before, we do not set targets for inventory levels for pack-and-hold product, as our buys are opportunistic and dependent on the availability of highly desirable branded product or key seasonal merchandise at strong values.

Our expanded retail store base also contributed to our growth in the quarter, delivering a $36-million increase in sales from new and non-comparable stores. We remain pleased with the performance of our new stores. We remain excited about our business prospects as we enter the second half of the year, and expect the continued implementation of the three key priorities that we outlined during our IPO to enable us to maintain our positive performance in the remainder of FY14 and longer term.

First, we expect to drive comparable-store sales as we continue to benefit from our enhanced off-price model to deliver the most sought-after brands, the right trends, and compelling value every day. As it relates to the third quarter, we began in a great position with substantial liquidity, less aged goods, and a plan to deliver more fresh product in each month of the third quarter. In addition, we had a higher penetration of pack-and-hold product as a percent of total inventory.

In addition, we believe we are starting to capitalize on the investments we have made in our home business. The home business outperformed the Company average in second quarter, and is gaining traction. We have performed well in housewares and luggage for some time, and now we are starting to see nice progress in home decor and home textiles. We look forward to providing more color on this opportunity on our future calls.

From a store execution standpoint, we have made substantial progress. With that said, we continue to identify ways to improve the customer experience. We are constantly conducting various tests within our stores, ranging from faster movement of receipts to the selling floor, to different fixture types. As soon as our testing platform indicates a positive return on investment, we look to roll out Company-wide as soon as possible. We have a number completed tests in roll-out mode that we believe will have a positive impact on comp-store sales in the fall season.

Second, our store expansion will continue. We are excited about our approved deals for 2014, which span from coast to coast. We now expect to add 24 new stores this year and close 2. Due to the later-than-expected delivery of new store facilities, we have decided to move three stores we had been planning to open in the fourth quarter to spring of 2015. This raises our expected store expansion for 2015 to 28 new stores. Our 2015 pipeline is shaping up well, and we continue to believe that we have significant white space for growth to reach 1,000 stores over the long term.

Third, we expect to enhance our operating margins as we continue to optimize our initial pricing and markdowns. Also, continue to tailor our assortments by store, and remain vigilant with inventory management disciplines. Operating margins are also expected to benefit as we grow our top line and leverage fixed cost.

And now I would like to turn the call over to Todd to review our financials and outlook in more detail.

Thanks, Tom, and good morning, everyone. Thank you for joining us today.

We are extremely pleased with our second-quarter performance. We surpassed our top- and bottom-line guidance, and saw progress across our key operating metrics, including strong comp-store sales; expansion in gross margin; leverage in operating expenses; and lower depreciation, amortization, and interest expenses. We are obviously very happy with the performance for the quarter and for the first half of the year.

I will begin with a review of our operating results. For the second quarter, as Tom indicated, total sales rose 8.3%, and included a comparable-store sales increase of 4.7%, following a very strong 7.8% comparable-store sales gain in the second quarter last year. Comparable-store sales trended positively throughout the quarter, and ended strong, with July comps ahead of May and June.

Gross margin was 38.2%, representing an increase of 50 basis points versus the second quarter of last year. This improvement more than offset a 40-basis-point increase in product sourcing costs, which include costs to process goods through our supply chain and buying costs, both of which are reported in selling, general and administrative expenses. The continued improvements in the freshness of our inventory and localization efforts has helped to drive our strong sales results, and deliver good margin expansion year to date, very much in line with our plans.

As a percentage of net sales, selling, general, and administrative expenses, exclusive of advisory fees and product sourcing costs, decreased 70 basis points to 29%. Expense leveraging was achieved primarily in store payroll and other store-related expenses, as well as from other SG&A improvements. The improvement in leverage included a 20-basis-point benefit from a shift in timing of expenses to the third quarter. This was offset by a 30-basis-point impact of an unanticipated increase in legal reserves.

Our adjusted EBITDA increased by 23.8%, or $11.2 million, to $58.1 million, representing a 70-basis-point increase in rate for the quarter. Depreciation and amortization expense, exclusive of net favorable lease amortization, decreased by $0.4 million to $34 million. Interest expense decreased by $7.8 million to $25.5 million, driven by principal payments made on our Holdco notes and term loan, as well as interest savings on the Company's term loan as a result of the May 2013 refinancing.

Our adjusted income tax benefit was $0.6 million compared to a benefit of $7.2 million last year. The adjusted effective tax rate was 39.9% versus 34.5% last year. The increase in the tax rate is the result of certain tax credits not legislatively approved and available in the current year, and other one-time discrete items recorded in the prior year.

Combined, these resulted in an adjusted net loss of $0.9 million versus a net loss of $13.6 million last year. Adjusted net loss per share was $0.01 versus a loss of $0.19 last year. Our weighted average shares outstanding was 74 million shares versus 72.9 million pro-forma shares last year.

For the first half of FY14, total sales rose 7.1%, and included a comparable-store sales increase of 3.6% following a 5.5% comparable-store sales gain in the spring last year. Gross margin was 38.1%, representing an increase of 60 basis points versus the first half last year. This improvement more than offset a 30-basis-point increase in product sourcing costs.

As a percentage of net sales, selling, general, and administrative expenses, exclusive of advisory fees and product sourcing costs, decreased 40 basis points to 27.9%. Expense leverage was achieved primarily in store payroll and other store-related expenses, as well as from other SG&A improvements. Additionally, as I mentioned before, a small portion of the leverage gain versus our previous expectations is due to timing of expenses between the second and third quarter.

Adjusted EBITDA increased by 18.9%, or $23.9 million, to $150.4 million, representing a 70-basis-point increase in rate for the spring season. Depreciation and amortization expense, exclusive of net favorable lease amortization, decreased by $0.9 million to $68.7 million. Interest expense decreased $15.5 million to $52.1 million, driven by principal payments over the past 12 months and the May 2013 refinancing I mentioned earlier.

The adjusted effective tax rate was 40.3% versus 29.6% last year. The increase in the tax rate is the result of certain credits not legislatively approved and available in the current year, and other one-time discrete items recorded in the prior year. Combined, this resulted in an adjusted net income of $17.7 million versus an adjusted net loss of $7.4 million last year. Diluted adjusted net earnings per share was $0.23 versus a loss of $0.10 last year. Our diluted shares outstanding was 75.6 million shares versus pro-forma basic shares outstanding of 72.6 million last year.

Turning to our balance sheet, merchandise inventories were $711.5 million versus $748.3 million at August 3, 2013. The decrease was primarily driven by a comparable-store inventory decline of 18% as part of our ongoing initiative to reduce inventory levels, increase inventory turnover, and ultimately drive incremental sales through continually improving product offerings. This decrease was partially offset by a $41-million increase in pack-and-hold purchases and inventory related to the opening of 20 net new stores since August 3, 2013.

Accounts payable increased $8.9 million to $564.5 million versus the end of the second quarter last year, representing 76 days of accounts payable outstanding, reflective of our normal payment terms for inventory. Our year-to-date cash flow provided from operations was $52 million, which was offset by $94 million in cash spent for capital expenditures and $62 million in cash used in financing activities, primarily debt repayments.

We expect 2014 net capital expenditures of approximately $180 million, net of $40 million of landlord allowances. This includes approximately $70 million for store expenditures, and approximately $30 million to support continued distribution facility enhancements. We continue to expect to use the remaining capital to support information technology and other initiatives, including approximately $40 million related to the construction of our new corporate headquarters.

We will continue to utilize free cash flow to pay down debt when available. Our debt totaled $1.373 billion at quarter end. Following quarter end, on August 13, we refinanced and replaced our existing term loan facility with a $1.2-billion term loan priced at LIBOR, subject to a 1% LIBOR floor, plus 3.25%. The proceeds from this new loan, along with a $217-million draw on our ABL, were used to redeem all of our higher-cost debt, which included $450 million of 10% notes, and approximately $70 million of 9% notes.

We also repaid our previous $830 million term loan, which was at the same rate as the new facility. The new term loan has a seven-year maturity with a minimal 1% annual amortization paid quarterly. We also renewed our $600-million ABL facility for an additional five years, taking advantage of current market pricing.

The new capital structure is expected to reduce interest expense for the second half of 2014 by $18 million, benefiting EPS by approximately $0.15, and by an estimated $40 million for FY15, benefiting EPS by approximately $0.31. The new debt also has no prepayment penalties and fewer covenant restrictions than our previous capital structure.

Concurrent with the new debt structure, the Company has also put in place interest rate caps to hedge against interest rate increases in the future for a majority of the debt. As Tom mentioned earlier, three stores that had been planned for the fourth quarter of FY14 will now open in the spring of FY15. This will bring our expected FY15 new store openings to 28 for the full year, and our expected spring openings to five to eight new stores.

Turning to our guidance: We are raising our FY14 outlook based on better-than-expected sales and net income performance during the first half of the year, and our expectations for the balance of the year, including a reduction of interest expense associated with the debt refinancing. For the third quarter of FY14, ending November 1 this year, we expect net sales to increase in the range of 6.4% to 7.4%; comparable-store sales to increase in the range of 3% to 4%; interest expense to approximate $17 million, reflecting the debt refinancing; adjusted net income per diluted share in the range of $0.09 to $0.12 on 75.8 million diluted shares outstanding. This compares to an adjusted loss per pro-forma basic share of $0.05 in the third quarter of FY13. And we also expect to open 17 new stores and close 1 existing store, resulting in a total store count of 539 at the end of the third quarter.

For the full FY14, ending January of 2015, we currently expect total sales to increase in the range of 6.5% to 7.2% versus our previous expectation of an increase in the range of 5.8% to 6.8%, and comparable-store sales for the full year of approximately 3%, at the high end of our previous guidance. These estimates include a comparable-store sales increase of 2% to 3% in the fourth quarter, consistent with our previous guidance.

The fourth quarter last year benefited from colder weather during most of the quarter, which was a key contributor to performance in coats and in other cold weather-related items. We also experienced disruptions from the unusually stormy winter weather that affected many parts of the country last year. The expectation is for more normalized weather this winter.

Our full-year gross margin rate, net of product-related costs, remain unchanged from our earlier expectations. Adjusted EBITDA margin expansion for the full year is expected to be in the range of 20 to 30 basis points versus our previous expectation for 10 to 20 basis points. This reflects our current expectation for stronger sales, which improves SG&A leverage, partially offset by our continued expectation for occupancy deleverage.

We expect interest expense of approximately $85 million, a tax rate of 40%, and fully diluted adjusted net income in the range of $1.52 to $1.58 per share, utilizing a fully diluted share count of 75.7 million shares. This compares to our previous expectation for fully diluted adjusted net income in the range of $1.25 to $1.35 per share. We also expect to have opened 24 new stores and closed 2 existing stores, resulting in a total store count of 543 at the end of the year.

In summary, with the second quarter, we have recorded six consecutive periods of sales and profit growth, which is the direct result of the improved execution of our off-price model. We continue to believe we are in the early stages of maximizing the power of our dynamic operating platform, and believe our strategies have us positioned to continue our success in the second half of the year and the longer term.

I will now turn the call back over to Tom.

Thanks, Todd. In total, we are very proud of our second-quarter and first-half results. And as our guidance suggests, we continue to expect FY14 to represent a strong year and another period of significant accomplishments toward our long-term goals. We remain confident in our ability to continue our positive momentum in future years, given our dynamic operating model, our disciplined execution, and the significant runway ahead on our growth strategies.

Operator, we are now ready for questions.

(Operator Instructions)

Paul Lejuez, Wells Fargo Advisors.

What percentage of your assortment would you consider to be better and best in terms of brands and where do you see that going longer-term? Then I'm also just curious about your comp performance at some of your older store classes versus the younger classes of stores. Where are you really seeing the comp being driven? Which classes are outperforming? Thanks.

This is Tom. I will take the first question and then I will Todd address the second question. As far as better and best, we just continue to grow that as a percent to our total.

We really haven't really stated exactly the level, but we're very pleased with the progress we have made overall. We really feel that's part of our formula for growth in the future.

The good news is we haven't had any real resistance to the -- obviously, from the customer -- based on our comp performance as we've added more better and best products. So we really feel it's part of the formula, an important part of the formula, and we're going to continue to push hard to deliver more better and best product on our selling floor.

This is Todd. I will take the question on comp store sales. As has been the case for a good while now, what is the key indicator of where we have strong comps is where we execute well.

We did have positive comps across all of our major territories for the quarter so the consistency of performance continues to get better across the store base, but when we look at which stores perform better, it really doesn't have to do with vintage, it doesn't have to do with geography, it really has to do with execution within the four walls. The good news, as a full group, the entire group of stores is performing better, so there's really not a correlation with age or size.

Got you. Could you talk about any categories that maybe underperformed your expectations?

I will take this one. Really the only category that we were unhappy with, and it's really a continuation from the first quarters, our Baby Depot business. Right now it's underperforming the Company. We're working really hard to get that turned around and we really feel that hopefully in the fourth quarter and beyond we will have a strategy in place that will correct that deficiency.

John Morris, BMO Capital Markets.

Congratulations on a great quarter everyone. First of all -- really gross margin and SG&A questions.

First of all, Todd maybe, just give us a little bit more color and remind us a little bit more about the increase coming from product sourcing, what your initiatives are there, how you expect that to pan out in the back half in terms of those increases that you had been seeing. I know it's not a new thing; I just want to get a little bit more color behind it and understand where the payoff is.

And then on the SG&A side, with the increase that you saw on SG&A, is that related to expansion of the buying team? And if so, when do we begin to anniversary some of that and what is the outlook there?

As it relates to product sourcing costs, the year really from a, obviously a sales standpoint, we're very pleased with how it's shaping up, but how the expense structure is trending is very much in line with how we expect it for the year. The product sourcing costs are up, but it is absolutely in support of the buying model, as our buyers are buying more goods opportunistically and we are taking advantage of the great deals that are in market. Some of those goods, we have to touch a little bit more.

The good thing is, this has been a lot of quarters in a row now where the merchant team has done a very good job of understanding what the right pricing to the customer is out of the gate and making sure that the price we buy the goods at is covering the product sourcing costs that we are going to have to flow those go through. So our margin, our gross margin, and our margin for our after-product sourcing costs for the full year and so far through the year is very, very much in line with our initial plans.

So as I indicated in the initial comments, we're basically right on where we thought we were going to be for gross margin less product sourcing cost. So that's working the way we expect it to and we will continue to flex our infrastructure to support what the merchants are executing.

On the SG&A front, that's really coming out, as we expected, as well. The only thing that was unexpected, as we indicated in the script, is we did have a legal reserve increase that we were not anticipating, but we will be able to cover that for the whole year and we were able to for the first half,.

So the expense structure is really shaping up the way we thought. The only thing that's different is our sales are a little better so far during the year and that's giving us a little bit of leverage for the full year versus how we originally expected it to play out.

Thanks. Good luck for fall.

Brian Tunick, JPMorgan

I will add my congrats as well. Two questions. Maybe from a traffic perspective, we know it's not easy out there, you're clearly outcomping your peers, but between your new marketing campaign, testing, new brands, just a lot of things you've made changes the last few years, what you think is holding back traffic to your stores?

And then the second question, really on inventory terms, and again, versus your peers, I think you've mentioned before, you carry 10,000 to 12,000 coats a year on the selling floor. So just wondering where are you in making the selling floor more productive?

What's happening to women's sportswear? Anything you could share with us of how you're thinking about the coat inventory going forward?

This is Tom. I'll talk about the traffic. Our traffic, obviously, as I stated, was flat for the quarter. We're working hard in terms of delivering improved assortments on the selling floor. We really feel that's going to pay dividends in the future overall.

We've worked hard, our marketing team has worked really, really diligently on becoming more and more efficient in terms of how we deliver the message to the customer, so we're able to, in the fall and holiday season, we're going to be able to deliver more GRPs to our customers than we have previously and really, especially in network TV. Those are the things that we're doing. We really feel that our new marketing campaign that we're working on right now, the [stal] positioning and customer testimonies is resonating really well with our consumers so we feel that, that's when help us overall.

We've increased our circulation, our cadence of direct channel telecommunications, both in e-mail and direct mail, so we've worked on all those, but as we continue to execute the model and continue to deliver value, we really feel confident that the traffic will improve. As other retailers have indicated on other calls, they've had a decline in traffic. So the one thing we're really encouraged by is the fact that our conversion is very good in the stores, our customer likes when they get in the store, they like what they're seeing, and obviously, they're buying more product overall.

As far as turn goes, we finished with 18% less inventory on a comp store basis than last year. Our turn was 22% faster than last year inventory turns. We feel very good about that, but we have a lot of opportunity to continue to improve our comp store inventory turns.

We've made significant progress over the last five years and we've really worked on every aspect, mostly on reducing the amount of aged goods that we have on our selling floor, especially in the coat area. We have done, our merchant team has done an outstanding job of reducing the amount of inventories in coats that we have carried into the spring season, significantly less than we had previously. We are able to utilize that square footage in the store to be more productive, but also we have less inventory tied up in that kind of product.

So I feel we've made a lot of progress. We need to continue to work harder on increasing our turns. That is going to be an ongoing, long-term strategy for us to continue to increase our terms.

That comes from product selection, it comes from improved weekly sell-throughs, [selectivities] as I mentioned. So, it's an ongoing strategy for us, and we really feel that, even though we've made a lot of progress, we feel that we can continue to make even more.

All right. And if I could, one housekeeping question for Todd. Just the average size of the new store leases that you guys are signing for next year?

I can address that. As you know, in 2013, the average was around 60,000 square feet. In 2014, it was around 63,000 square feet. The ones we have signed so far for 2015 is around 59,000 square feet. So we continue to look to reduce the size of our box.

All right. Terrific. Thanks so much. Good luck in the fall.

Stephen Grambling, Goldman Sachs.

Thanks for taking my questions. Both are really just following up on actually Brian's line of thinking on traffic here. The first would just be as I look at the quarter, or as you look at the quarter, did traffic term positive when you saw the comps accelerate?

As we went through the quarter, our comps, as Todd articulated, our comps did improve overall. We had a very nice July performance and it just built as we were finishing up on July. We really don't give traffic by month, to be honest with you, but we were pleased with our comp performance as we completed the second quarter.

Okay. Fair enough. And then as you think about longer-term, and you look at driving traffic, can you just talk about some of maybe even digital efforts and whether that's mobile or online and are you thinking about any opportunity for improving an omni-channel experience with something like buy online and pick-up in stores? Is that even something that, from an infrastructure standpoint, is possible?

Digital marketing and social media have become an important part of how we go to market. But that said, it's still a small piece of our media spend in general, but long-term we want to continue to evolve our media mix to include more digital. We want to be more relevant with the customer. But we're always testing and measuring and trying to improve our marketing overall.

Our e-commerce site, that obviously helps us from a digital perspective. We've seen nice growth in e-commerce over the years now. We see that continuing to grow.

Will it be a high percent to total? Not sure. But we still see a lot of growth overall in terms of our e-commerce business, so we're pleased with what's happening there right now. That will also play into the, obviously, the social media and et cetera.

Great. Thanks. Best of luck in the back half.

Kimberly Greenberger, Morgan Stanley.

Really terrific performance here in the second quarter. My congratulations.

I wanted to ask, Tom, about the inventory management. Obviously, you have been working on improving in-store inventory turns now for five years. Is this something where we could actually see progress every year for the next one, two, three, four years, or do you think you're getting to the point with this significant progress being made here in 2014 that it will largely be done by the end of the year this year?

I think we're in the early innings of improving our inventory turns relative to what some of the other people in our channel are doing currently. I think that we're going to continue to have improvement.

We're being very disciplined in terms of our receipt management, our inventory management, and I really feel that we can continue to improve the turn and reduce our comp store inventories for the foreseeable future. We just have a lot of catching up to do, so we really feel that there's -- in the future, we're going to continue to improve.

Terrific. Todd, the 50 basis point improvement in gross margin, was that entirely merchandise margin driven?

Yes. The increase is really coming from the initial margin and net of mark downs. As I indicated before, we've continued to improve these last many quarters now in terms of striking that right balance when our buyers are out with the vendors of understanding what a product is likely to selling at and negotiating to the right initial margin.

As we've improved what we buy and how we allocate it, how we localize it, we have been selling more through at full rate and so that has expanded our margins from merchandising. As we bought more opportunistically, our supply chain costs and other product sourcing costs have gone up a little bit, but as we've indicated all along, we have more than covered that and the net rate of those is coming in right where we wanted it to. We think we're striking a very good balance there to drive great value on the selling floor.

Okay. Terrific. My last question is, you've got 17 stores opening here in the third quarter, how many have opened so far and how is that process going?

The stores are weighted towards the end of the quarter. We're happy with where we are with those stores at this point. The details of when we open them, we really haven't share.

Okay. Thanks so much and good luck.

Ike Boruchow, Sterne Agee.

It' s actually Tom Nikic on for Ike. That's for taking my question. Congrats on a great quarter.

I just wanted to ask about the guidance for the back half. You're calling for a sequential deceleration in both Q3 and Q4 on the comps and if my math is correct, to hit the EBITDA guidance, you need margins flat to slightly down in the back half.

I'm just wondering if you guys are just being conservative in a relatively challenging retail environment or if there's something in particular in the back half that we should be thinking about? If there's anything other than that? Thank you.

This is Tom. I'll take that comp question. We looked at the third-quarter as a plus 3% to plus 4%. When you look at our spring season, we picked up 3.6%, so we really felt that, that was right in the middle of it.

We did have a very strong second quarter on top of a very strong second quarter, but historically we've been underdeveloped in the second quarter, so we're catching up there overall. But we feel that 3% to 4% in the third quarter is a good number relative to our total performance in the first half of the year.

As far as the fourth quarter go, fundamentally we feel that we are operating very, very strongly. Really, fundamentally, there really isn't any difference; we just feel it's better to be cautious this far out from the fourth quarter, so we felt 2% to 3% was the right number overall.

We know it's going to be a highly promotional quarter, as it always has been, but we really feel that fundamentally, we have done a pretty good job of offsetting any of those promotional by delivering more and more value. We continue to enhance our gifting strategies for the fourth quarter so that should help us, but we just that it's prudent to be, this far out, to have a 2% to 3% comp, but fundamentally, we feel we are in good shape.

This is Todd. I'll just add to that. As Tom indicated, we don't think anything is fundamentally different from our previous thinking. We did have a small amount of expenses shift from Q2 to Q3, and with the somewhat more conservative numbers that we're utilizing in the guidance for the Q4, we do have a little bit of occupancy deleveraging in the fourth quarter, as we had called out in previous guidance. So the way we are thinking about it, is the year is absolutely shaping up very much in line with how we were originally thinking about it, except our flow-through to adjusted EBITDA, we expect to be a little bit higher as our sales so far this year have outpaced our original plan.

Very helpful. Thanks guys.

John Kernan, Cowen and Company.

Can you just give us an update on the West Coast buying office? Any update on some of the product you're seeing come out of there? And then I hate to ask a boring model question, but it looks like your implied interest expense guidance for the fourth quarter is around $15 million. Is that the run rate we should expect on a quarterly basis into next year after the refinancing?

I'll take the West Coast office. We feel good about what we've done in the West Coast so far this year. We were able to get access to a lot of product that we wouldn't have got access to previously. But we're still in the early stages. We opened the West Coast office in October of last year.

We're building out the team; we feel very good about the team. It's a small team, in general. As always, we want to be very planful, in terms of how we expand that office out there, but we're getting good access to a lot of good products and ladies sportswear and juniors sportswear, et cetera. But we're really in the beginning stages and we really feel most of the benefit is going to come in future years.

John, this is Bob LePenta. I'll take the question on interest expense in the back half of the year. The guidance we gave for the interest saved due to the refinancing for the back half of the year, the refinancing took place on August 13, so you don't get a full third quarter's benefit, so when you look at what third-quarter save is going to be, it is a little less than what you're going to expect in fourth quarter. You can't really straight-line it, but if you back into taking first half of year actual expense and then the guidance we gave for Q3, it gets you to a fourth-quarter number that is going to be pretty consistent with the [one] rate for [2015].

All right. That's helpful. Thank you.

Dana Telsey, Telsey Advisory Group.

Congratulations on a terrific quarter. Can you talk a little bit about new store productivity and what you're seeing out of some of the new stores and what your expectations are for them to ramp compared to other stores that you've had in the past? Lastly, as you think about the SG&A buckets, any change to store labor and the processes that are going into store labor? Thank you.

On store productivity, as Tom indicated before, we have continued over these last couple of years to look at a broader range of square footage that we can operate our model in. Given the inventory management, we continue to look at smaller stores, those that we're -- that we've been underwriting and been looking at, most of them are in the 50,000 to 60,000 square foot range and the average is coming down again, as Tom indicated.

Our hurdles for productivity at the top line and bottom line really haven't changed over the last couple of years. Our performance versus the underwriting model has continued to get better as we have moved along in time, so we are -- undoubtedly, we're happy with our underwriting process, we're happy with the new stores that we've been getting and the good thing is with our continued strong performance we have more and more landlords that want us in their properties. So we're excited about a lot of the stores that are already underwritten for this next year and those that we expect will come in for the rest of the year.

So we're happy with that productivity. The hurdles haven't changed. The performance has continued to come in closer to the underwriting model.

As it relates to how they ramp, still very consistent with what we've said in the past. Our new stores mature very quickly and are cash flow positive in the first year. So we are happy with our real estate.

Great. And then just on labor, anything changing on the labor side?

We did get good leverage on store labor. There are a number of initiatives that the stores team has put in place over the last number of years.

A lot of it had to do with simplifying what we do in the stores and make the shopping experience easier and simpler for our customers. By simplifying the way we display goods and the way we flow good, it has resulted in some good leverage on store payroll. The benefits that we've seen in the first half of the year, we expect to see some of that in the back half and that's really embedded in the guidance that we have given.

Thank you very much.

David Glick, Buckingham Research.

Congratulations to the team on such a strong quarter. I have a question about the free cash flow generating ability of the Company. If you'll think about some of your initiatives and how they are shaping up, CapEx appears like it's coming down once you get past the headquarters investment this year. You're clearly generating some working capital benefits from reducing inventory and your net income is growing very nicely through reduction in interest expense and improved operating metrics.

I was wondering if you could give us an updated thought on how you're thinking about the free cash flow generation ability of the Company. Whether you have any new thoughts on what target leverage you are looking for and at what point in what leverage would you have to be at to start thinking about returning cash to shareholders through either dividends or share repurchases?

I'll take that, David. Just at a high level, all the comments that you make are right, directionally. All the things that we're doing, we think long-term are going to improve free cash flow.

We have said for the next foreseeable future, our priority with free cash flow is going to be to pay down debt. It will be something we evaluate every year. We haven't set any targets for leverage and will look every year at what we think the best opportunity to add shareholder value will be. As we make those decisions, we will share them with you.

Okay. Thanks. And then just a follow-up question for Tom. One of the unique things about the Company is the large store size and as I think about -- and obviously that gives you the opportunity to distort certain categories -- but if you think about the objective of reducing in-store inventory and you layer that into a larger box than the industry average, does that create some merchandising challenges for you guys and how do you deal with those potentially conflicting objectives? And alternatively, are there some categories that you could introduce to take advantage of some extra space that you may be generating or some categories that you can significantly expand?

First of all, we really feel that we're comfortable with a 50,000 to 60,000 square-foot box now. As I've explained a few times, there are certain categories that we distort that need extra square footage versus our competition.

Baby Depot requires 8,000 to 10,000 square feet, coats needs about 8,000 to 10,000 square feet, and tailored clothing, 8,000 to 10,000 feet. Apples-to-apples, we think we're pretty good shape when we get to 50,000 to 60,000 square feet overall.

As far as adding other categories to our assortment, we're always looking at things that we want to add to our assortments overall. Nothing really at this point in time to report that's really extremely meaningful overall. We're just going to operate stores with less inventory and make the experience better for the customer, easy to navigate. Even though we have a big box, as we reduce inventory, we can continue to open up the store a little bit and just make it easier for the customer to get around.

Our customers have really voted for, obviously, less inventory in our stores based on current performance overall. But going forward, we're just going to really focus on boxes that are between 50,000 and 60,000 square feet and we do own boxes that are bigger and they're just going to have less inventory in those stores and I don't think it's a challenge. It's just going to help the customers have a better experience.

Okay. Thanks for the color. Good luck in the second half.

It appears we have no further questions at this time. I would like to turn the floor back over to Management for any additional concluding comments.

Thanks everyone for joining us today. We look forward to speaking with you when we report our third-quarter results in December. Thanks.

Thank you. Ladies and gentlemen, this does conclude today's teleconference. We thank you for your participation and you may disconnect your lines at this time.