Carter's Inc (CRI) 2010 Q2 法說會逐字稿

Ladies and gentlemen, please stand by; we are about to begin. Good day, everyone and welcome to Carter's second quarter 2010 earnings conference call. On the call today are Michael Casey, Chief Executive Officer; Richard Westenberger, Executive Vice President and Chief Financial Officer; and Jim Petty, President of Retail Stores. After today's prepared remarks, we will take questions as time allows.

Carter's issued its second quarter earnings press release today before the market opened. The text for the release appears at Carter's website at www.carters.com under the press release section. Additionally, presentation materials for today's earnings conference can be accessed on the Company's website by clicking on the Investor Relations tab and choosing conference calls and webcasts on the left side of the screen.

Before we begin, let me remind you that statements made on this conference call and in the Company's press release other than those concerning historical information, should be considered forward-looking statements and actual results may differ materially. For a detailed discussion of factors that could cause actual results to vary from those contained in the forward-looking statements, please refer to the Company's most recent Annual Report filed with the Securities and Exchange Commission.

Also on this call the Company will reference various non-GAAP financial measurements. A reconciliation of these non-GAAP financial measurements to the GAAP financial measurements is provided in the Company's earnings release. And now I would like to turn the call over to Mr. Casey.

Thank you very much. Good morning, everyone. Thanks for joining us. We have a presentation on the website. It will give you a good analysis of our second quarter results. Before we walk you through that presentation, I'd like to share some thoughts with you.

Overall, our second quarter earnings are in line with the guidance we shared with you on the last call. As you know, we had a very strong start to the year. Our first quarter sales were up 15% and our adjusted earnings per share were up 87%. Because we knew that some of the first quarter growth reflected the benefit of earlier demand due to the Easter shift, and the timing of orders from our wholesale customers, we didn't forecast much growth for the second quarter. With that said, our first half sales were up 8% over the first half of 2009. And adjusted earnings per share grew 47%.

These are very solid results, particularly given the difficult environment and the fact that we're comping up against a record level of performance in 2009. Our first half results reflect very good performance with our spring 2010 product line. Our wholesale customers had very good growth with our brands, earned better margins, and are very clean on inventories heading into the fall selling season.

Fall 2010 selling is off to a good start. And we're seeing good orders for spring 2011 products, which begin shipping later this year. For the second half of this year, we're expecting good topline growth, up about 8%. That would bring 2010 sales to a record level of $1.7 billion, up about 8% to last year. That growth is in line with our previous guidance.

We're currently expecting earnings growth of about 10% for the year, again good growth building on a record level of earnings last year. Our latest earnings estimate is in line with what we initially forecasted for the year, but reflects less robust growth than we forecasted on our last call, due to lower traffic in our retail stores, and rising freight costs. I'd like to highlight some of the more noteworthy developments since our last call.

In June, we launched a refresh of our core baby product offering. This is the bread and butter of our Carter's brand, which we call Little Layette. It includes many of the everyday essentials for a newborn to a 12 month old child. It's an expanded offering of products that are more special, more giftable, it has an expanded color story, providing more choices for the mom and gift giver, and price comparable to last year, providing a better value for the consumer.

We believe it's a traffic driver for our wholesale customers and our stores. It launched with our largest wholesale customers early in June and in our stores late June. The sales of little layette, including replenishment, are expected to be up over 10% this year. We marketed this launch with national advertising, focused on maternity and parenting magazines. We also supported the launch with new fixturing in over 1,000 wholesale customer doors, and new point-of-sale branding in over 3,000 doors. I'd encourage you to visit the top retailers in our stores to see the Little Layette product line.

In June, we rebranded our Just One Year brand at Target with the launch of Just One You. In addition to being more relevant to a size range that extends beyond the first 12 months, we refreshed the Just One You color story to be brighter and more appealing. We expect the Just One You brand will be fully set at Target next month.

At Wal-Mart I'm very happy to tell you that based on the success of a 50 door test earlier this year we received new orders for an expanded offering of our Child of Mine brand, which should be shipping later this year. If you recall, Wal-Mart was the only component of our business that didn't grow in 2009. With the success of our expanded product offering earlier this year, we're very pleased to tell you that Wal-Mart should be back on a growth track starting next year.

At OshKosh, we saw better performance over the counter with the spring 2010 line. Our wholesale customers are seeing better sales and margins with the brand. We're also receiving very good feedback on our spring 2011 line, which begins shipping later this year. OshKosh bookings for spring 2011 are currently expected to be up about 10%.

As you know, earlier this year we recruited new leaders for the OshKosh brand and for its design team. They joined us in time to have an impact on our spring 2011 line. We're arranging an event later this year to enable you to meet these new leaders, and to see the improvements they've made to the spring line.

In our retail segments, we saw a slow start to the quarter. We expected traffic in April would be lower, given the shift in the Easter holiday. But consistent with what most retailers reported, traffic in May was also lower than expected. June traffic was better than April and May, but lower than we had planned. Jim will address retail performance in more detail.

Generally speaking, we believe we were less promotional than our competitors, and as a result we attracted fewer customers to our stores. Given strong product performance earlier this year, we had less clearance inventory to offer consumers a better deal, and new product deliveries came in later than last year. As a result, we were less promotional in the second quarter, which helped improve margins, but impacted comps. With the inventory levels and mix improving, comps are also improving. The West Coast is the first to receive new product, and the comps there are meaningfully better.

Partially offsetting the impact of lower traffic in our stores were sales generated by our new e-commerce initiative. E-commerce is off to a good start. As I shared with you on previous calls, the sales and earnings contribution near term are not expected to be material to our total business. But we're using e-commerce as a tool to strengthen our relationships with existing consumers, and we're expanding the reach of our brands to new consumers.

Since our last call, we also gained more visibility on supply chain costs. As you know, apparel companies are facing higher product costs for 2011, cotton prices are up significantly, wages and currency valuations are rising in Asia and freight costs have increased. Cotton is the most significant of our current supply chain challenges. We don't buy cotton. Our suppliers do. We buy finished product, and our products are largely cotton-based.

As a result, our product costs for the spring 2011 line are currently expected to be up about 10%. Recent reports indicate cotton prices are stabilizing and beginning to decrease. We'll have more visibility on the benefit from the improving trends in cotton prices when we update you again in October. To help partially offset these cost increases, we're selectively raising our prices on certain spring 2011 products.

Our strategy will continue to be to drive strong topline growth with great product, and high-unit velocity. We're raising prices where we believe unit velocity won't be meaningfully affected. We're beginning the fall 2011 product development process. Fall is the larger of our two seasons. We plan to pursue additional opportunities to increase prices in the second half of 2011.

Building a higher margin business is one of our top priorities. If you look at our track record, you'll see we've been successful achieving this objective. In 2009, we earned a record level operating margin of about 13.5% and we expect to make progress on that performance this year.

Improving our operating margin will continue to be a major focus of our Company, but the spike in cotton and freight costs -- given the spike in cotton and freight costs, improving our operating margin in 2011 may prove to be more challenging. As the year evolves, we'll get more clarity on 2011 and we'll let you know what's possible next year. At this time Richard and Jim will walk you through our results and we'll start with Richard.

Thank you, Mike. Good morning, everyone. On page two of this morning's presentation, we have some highlights of our second quarter performance. At a high level, our consolidated sales and earnings on an adjusted basis were comparable with a year ago. We were pleased with our wholesale and mass channel topline performance, but our comp store sales at retail were below what we had planned. Overall our earnings were in line with our expectations, and consistent with our previous guidance.

Our second quarter is the lightest of the year, in terms of sales and earnings, so I'd encourage you to focus on our first half performance. As Mike said, on this basis, our consolidated net sales increased 8%, and our adjusted earnings per share increased nearly 50%. Beyond our financial results, we've had a successful first half in terms of advancing against our key priorities, including moving forward with some decisions on our capital structure, which I'll discuss more in a few minutes.

Turning to page three and our revenue performance for the quarter, overall our sales for the second quarter were comparable to last year. Carter's retail store sales increased $3.5 million, driven by new door growth and e-commerce sales, partially offset by lower comps.

Carter's wholesale sales increased about $3 million, or 3%, as strong product performance continued throughout the second quarter. Recall that Carter's wholesale sales were up 20% in the first quarter, in part driven by earlier customer demand. So we were pleased to post the 3% increase in the second quarter.

Despite a fair amount of continued noise in the market place regarding the strength and consistency of consumer demand, we've been very pleased and we think our wholesale customers have been as well, with how our products have been performing. OshKosh retail store sales were flat to last year, as the benefit of new door growth and e-commerce was offset by negative comp store sales. As Mike mentioned, we believe we've identified the factors which contributed to our comp performance, and Jim will comment more on our retail segment results in a moment.

Mass channel sales declined $5.4 million, or 12% to last year, due to the reduction in brand wall space at Wal-Mart. Strong sales performance to Target helped to offset a portion of the decline in sales to Wal-Mart. Our results in the mass channel in the second quarter were stronger than we had forecasted, as a result of earlier demand for Child of Mine product by Wal-Mart.

Our second quarter P&L is on page four. We had nice improvement in gross margin during the quarter. In rate terms, gross margin improved 160 basis points over a year ago, due to improved product margins in all of our business segments.

At a high level, expenses increased 5% to last year, and were up about 130 basis points in rate terms. The lack of rate leverage was largely due to our lower topline revenue performance. Royalty income was up slightly to last year despite the loss of sales of licensed product on the Child of Mine brand wall.

Interest expense was flat to last year. We've been running lower versus a year ago since market interest rates have been declining. But this quarter included the write-up of approximately $500,000 of debt issuance cost, relating to our $100 million term loan prepayment in the quarter. Excluding this item, our interest costs were down from their level a year ago. From a bottom line perspective our earnings per share on a GAAP basis increased 14% as a result of the expenses in the prior year related to our work force reduction and facility closure cost. On an adjusted basis second quarter earnings per share were comparable to last year.

Page five is a recap of SG&A. SG&A increased $4.6 million over last year. Expenses related to retail door growth and a full quarter of e-commerce expenses drove our higher SG&A for the quarter. We also incurred higher legal expenses in the quarter, largely relating to the accommodations issue. Offsetting these increases were lower expenses in other areas, including lower provisions for incentive and other performance-based compensation expense than a year ago. We've continued to control discretionary spending well across the organization.

The next page is included for your reference. There were no adjusting items in the second quarter of this year. Last year's second quarter included about $4 million in charges related to our restructuring activities. So again, I'll draw your attention to EPS for the quarter of $0.32 per share this year which is comparable to adjusted EPS from a year ago.

Page seven summarizes our business segment performance for the second quarter. In our Carter's businesses, the wholesale business improved its margins nicely as a result of continued strong product performance, and lower order cancellations, and lower off price channel sales. Despite the softer comp store performance, the operating margin in our Carter's retail business improved 130 basis points, due to lower product costs and lower levels of clearance sales. Mass channel operating income declined in the quarter, principally due to the loss of sales and royalty income from the Wal-Mart brand wall.

Last year's second quarter also included a vendor recovery, which made the comparison more difficult this year. OshKosh profitability declined in the quarter due primarily to the negative comp store sales performance at retail and also higher costs related to new stores and e-commerce. On a year-to-date basis, we have improved the profitability of OshKosh driven by better earnings in the wholesale and retail segments.

Our consolidated operating income, adjusting for the restructuring expenses a year ago, was essentially even with last year's second quarter, and our overall operating margin improved 10 basis points. The next several pages of the presentation include summaries of our first half performance. I won't cover these pages in detail. But I'll point out a few items.

We've had a very good first half. Our net sales increased nearly 8%, led by terrific performance in Carter's wholesale, and 9% growth in sales from our Carter's retail business. Our gross margins were up substantially, up 350 basis points reflecting lower product costs and excellent product performance. Our adjusted earnings per share of $1.03 represents a 47% increase over last year's first half.

Turning to page 12, we have a recap of a few key balance sheet and cash flow metrics. Overall our balance sheet continues to be very strong. We ended the quarter with $245 million in cash, reflecting our strong growth in earnings in the first half. Note that this cash balance also reflects that we paid down $100 million of our term debt in the second quarter. This payment reduces the Company's outstanding debt by about 30%.

Inventories ended the quarter up about 2%. Despite slower retail sales than we had hoped, the quality of our inventory remains excellent heading into the third quarter. We've continued to assess our capital structure and have reached some conclusions regarding our near-term strategy.

First, we decided to use a portion of our current cash position to reduce debt. By deleveraging we have improved our overall credit profile, and expect to reduce interest expense, while still retaining a significant amount of financial flexibility. We've begun the process of putting in place a new revolving credit facility. Our current facility expires in about a year, and we anticipate that this facility, along with our expected cash flow generation, will adequately address our liquidity needs for the foreseeable future.

Our intent is to use this new facility to refinance the remaining portion of our term debt which matures in 2012. As also reflected in this morning's announcement, our Board of Directors has approved a new $100 million share repurchase authorization. We have about $9 million remaining under the previous authorizations, so a total current capacity of $109 million. This authorization has no expiration date. We believe share repurchase will be a good way to return excess cash to shareholders over time.

Turning now to a few more details on the wholesale and mass channel businesses. First, in our Carter's wholesale business, which is summarized on page 13. As I mentioned earlier, we had continued good performance in this part of our business. Sales in the quarter were up 3%, and are up 12% for the first half. This is on top of 8% sales growth in Carter's wholesale in the first half of last year.

Over-the-counter sales of our spring assortment in our top customers have been very strong with first-half sales up 15%. Particularly encouraging has been the breadth of the strength of our wholesale performance in the first half. Over-the-counter performance is up solidly in all three major product categories, baby, sleepwear and play clothes for the full first half. We continue to have a positive outlook in wholesale, consistent with our previous forecast. We believe second half 2010 net sales in Carter's wholesale will be up in the high single digit range. Additionally, the outlook for spring 2011 orders looks good and based on the orders we have in hand currently, we're projecting high single digit revenue growth in this part of our business in the first half of next year.

On page 14, we've included some examples of the brand advertising that Mike mentioned, which we ran in national print media such as People and Parenting magazines in support of the Little Layette launch. We are planning additional brand advertising in the fall in support of back-to-school for OshKosh.

On the next page, in the mass channels, sales were down in the quarter, which reflect the decline in brand wall space at Wal-Mart. We continue to have very good performance at Target. Sales to Target were up 20% in the second quarter, and up 23% in the first half. As Mike mentioned, we now have greater clarity regarding the outlook for the Wal-Mart portion of our mass channel business. We now expect that we will return to growth mode again with this significant customer going forward.

For the balance of this year, we expect to ship approximately $8 million to $10 million of incremental volume to Wal-Mart that was not in our previous forecast as we support the go-forward brand wall strategy. Given that we're expediting this product from Asia, we're unlikely to have much of a profit contribution from this incremental volume this year. Revenues to Wal-Mart are still forecasted to be down in Q3, but we expect the incremental orders will ship in our fourth quarter, resulting in higher revenues from Wal-Mart overall in this period. Next year, though, is the more significant revenue opportunity. Right now we're anticipating that our Wal-Mart business will represent about $125 million of revenue in 2011, which obviously would represent significant growth of where we expect to finish 2010.

Turning to the OshKosh wholesale business on page 16. It's probably best to look at this business in terms of the full first half. Sales in this channel for the first half were down about 4%. We continue to project roughly flat OshKosh wholesale revenues for the full year of 2010.

We consider the spring season for OshKosh at wholesale to have been very successful. Sell-throughs and over-the-counter performance for our top accounts have improved this year, and from what we can discern, margins for these retailers have also improved. We think this portends well for spring 2011. Reception to the spring 2011 merchandise assortment has been very positive, and we are currently planning spring 2011 revenues in this channel will grow approximately 10%. With that I'll turn it over to Jim for some comments on retail.

Thanks, Richard. Good morning, everyone. As I stated on the previous call at the end of April, it is very important to look at our business on a first-half basis, which has been strong. That being said, Q2 was not as strong as the first quarter. Keep in mind, the second quarter is our smallest quarter of the year as it relates to revenue and earnings. The decline can be attributed to three main factors.

First, as expected, the shift in the timing of Easter holiday and Spring breaks as compared to last year, had a negative impact on our business in April. As a result, we believe that approximately 1 to 2 points of comparable store revenue in our second quarter shifted to the first quarter.

The second quarter has seen a decline in traffic. The traffic was lighter than we planned throughout the quarter. However, we've begun to see an improvement in this trend in July. In a moment I'll address some initiatives we have underway that should support continued improvement in overall traffic trends.

The third factor, which compounded the previous two, was inventory flow. Light inventory levels negatively impacted second quarter sales in two ways. For Carter's, the Company ended spring with less wholesale excess than planned. Although positive for the company, it limited retail's clearance sales in June. Although we ended the quarter down only 1% per door in inventory, we ran too lean on average throughout the quarter.

The category most impacted was our core baby business, which was down in inventory approximately 15% to LY on average throughout the quarter. For OshKosh, early fall deliveries hit stores three weeks later than last year, not arriving until the end of June, rather than the beginning. We have taken steps that we believe are necessary to better manage our inventory position going forward. The new fall and back-to-school merchandise is now in stores for both brands and is off to a good start.

Turning to page 17, as it pertains to the Carter's brand, Carter's total sales for the second quarter were up 3%. Comparable store sales ended the quarter down 4% with gross margin expansion across all major product categories. Although we experienced a traffic decline on the quarter, we continue our focus on in-store productivity, converting those customers who did walk through our doors at a higher rate than last year, while increasing the size of the average transaction. On a first-half basis, as you can see, all key performance indicators were positive, with the exception of transactions.

Total sales in the first half were up 9%. Comparable store sales for the first half increased roughly 2%, up against a nearly 7% increase from last year. As I stated previously, we feel that our inventory is well positioned as we head into the back half of the year, and again, the performance of our new product is off to a good start this quarter. In particular, our play clothes business, which represents over 40% of our assortment in both boys and girls, is performing positively and as inventory levels grow in the baby assortment, which is roughly 30% of our mix, sales are improving as well.

In addition, it is important to note, we are pleased with the performance of our new stores opened in the first half. They're off to a good start, and continue to exceed our expectations. Through the second quarter, we have opened 13 new stores and have 16 planned for the remainder of this year. Our confidence in our new store strategy continues to grow, with our ability to hit our pro forma expectations and produce meaningful comparable store sales increases in earnings during the initial ramp up years.

Moving on to the OshKosh brand on page 18. OshKosh total sales ended the second quarter comparable with last year. Comp store sales were down approximately 5%. However, on a first-half basis, comparable store sales were only slightly negative against a nearly 7% increase last year. As indicated by our key metrics, OshKosh results were most challenged by a decrease in traffic and the later flow of new fall inventory.

Encouraging, however, for the brand was the consumers' acceptance of our assortment, which is best demonstrated by the fact that conversion rate for customers who walked through our doors was up over 5% to LY. It is also important to note that this brand is playing in an arena that is much more competitive from an in stock position and promotional perspective as it relates to the competition from last year. Customer response to our marketing vehicles has been very strong with redemption levels higher than last year. Therefore, our focus will be on driving incremental traffic to our stores, which I'll discuss in further detail in a minute.

Moving on to our e-commerce business. After the first full quarter of business, we are pleased with the launch and the overall results. Business is in line with expectations and we are encouraged by our customer acceptance and builds in sight traffic and transactions. We continue to learn and develop customer insights.

For example, 50% of online buyers are new to our customer database and 70% of our purchasers are buying for multiple children. Also due to the fact that we are a cobranded site, we're encouraged that 25% of the orders contained both Carter's and OshKosh products. These orders on average are 50% higher than single branded orders. We're excited about the opportunity for growth afforded by this channel of distribution.

In closing, overall our confidence in the retail assortment, new store strategy, business model, and opportunity for growth remains strong. Our primary focus will be on driving traffic in a compelling and competitive retail environment. We expect to accomplish this by, first, capitalizing on the growth of our database, by increasing the distribution of direct mail collateral. Second, increasing the impact of our window and promotional signage to maximize walk by traffic and increase conversion. And, third, more effectively aligning our in-store marketing message, emails and e-commerce site to focus on a branded value message to provide a seamless experience for our customers. Now I'll turn it back over to Richard.

Thanks, Jim. On page 20, regarding our revised forecast expectations. As Mike mentioned, we've become more cautious in our outlook for the balance of the year, in light of our second quarter experience in retail and better visibility to higher transportation costs. We also think the broader economy and consumer spending are going to continue to be weak for the foreseeable future. For the second half, relative to our previous forecast, we've adjusted a few specific assumptions. First, we have moderated our retail revenue assumption from roughly a 4% comp to a 2% comp. We also believe that the competitive environment is likely to intensify in the second half, so we're a bit more conservative regarding our retail gross margin assumption.

Finally, our forecast now includes approximately $5 million of incremental freight costs, due partially to higher market freight rates versus our previous forecast and an assumption of additional air freight expense. The net of all of this is that we're projecting net sales for the second half up in the high single digits, with fourth quarter forecasted to be stronger than third quarter. An adjusted EPS in the second half is forecasted down in the high single digits. Recall that last year's third quarter was extremely strong across the board. In fact, it was a record quarter.

Particularly strong last year were Carter's wholesale and Carter's retail. Right now we're forecasting that EPS for the third quarter will be down in the low teens. Fourth quarter earnings are projected to be comparable with a year ago. With these assumptions, we would deliver solid full-year performance with EPS increasing approximately 10% over last year's adjusted EPS result of $2.15.

One of the most significant variables in our forecast relates to topline performance in our retail stores to the extent we're able to drive a higher comp than we likely would have some upside to this guidance. Before I turn it back to Mike, I wanted to point out that we've included some supplemental slides in the back of today's presentation, which include additional information on product costs and some of the inflationary issues that we and the entire apparel industry are facing.

We anticipate that we will have another good year in 2011 in terms of growing the top line. We believe we are winning at wholesale, and as we've mentioned, we expect the mass channel will also return to growth. We also believe we have plenty of growth ahead of us in terms of expanding our base of retail stores. We believe that the majority of higher product costs will be experienced in the first half of 2011 and that pressure will moderate in the second half.

But the sourcing environment is very fluid right now. We don't have very good visibility to fall product costs at this point. As we indicated in the release this morning with how we are modeling the business currently, we expect that our gross margins will be under pressure in the first half of 2011 and will be lower than what we achieved in 2010 in a much more favorable product cost environment. With that, I'll turn it over to Mike.

Thanks, Richard. In summary, we're projecting good growth in sales and earnings this year. Keep in mind, unlike many apparel companies and retailers, this growth comes on top of record performance in 2009. We share your concerns about the macro environment challenges. But we believe we're well positioned to weather the prolonged weakness in the economy.

Carter's sells multiple brands through multiple channels. We feel this is a real advantage and a difficult environment. Our business model enabled us to achieve exceptional results in 2009. It was our best performance ever, and we expect to improve on that performance this year.

We've got more work to do to prepare for 2011. But we do expect continued strong demand for our products next year. We'll continue to be focused on providing the best value in young children's apparel. We're the market leader in young children's apparel, with our brands being sold in over 15,000 doors nationwide. No other company in our space has that market position.

We're seeing very good product performance over-the-counter this year. We believe the best margin is earned on product that's selling well. So we'll continue to focus on strengthening the value of our product offerings and executing at a higher level to deliver the best possible performance for our consumers, our wholesale customers and our share holders, despite these near-term challenges. At this time we'll open up the call to your questions.

Thank you, sir. (Operator Instructions). We will pause for just a moment to assemble the question roster. And for our first question we go to Scott Krasik with BB&T Capital Markets.

Thanks. Good morning, guys.

Morning.

Richard, on the gross margins, specifically third quarter, can you give us a little more on the gives and takes to get to that low teens decline in EPS. I'm just not getting there.

Well I think it would be principally moderating our expectation in the retail business, Scott, and the fact that we've just moderated what we think the expectation should be for us, given the competitive environment, given that the top line will likely be a little softer than we had originally projected. The majority of the pressure in gross margin is coming from retail. We also continue to have declines in the Child of Mine business with Wal-Mart in the third quarter. And that also puts some pressure on margins.

Right. But that was expected. So is it just that the incremental sales that you'll get this year, just have a lower flow through than you previously expected because of the promotionality?

Yes. I think on balance, that's right.

Okay. Does your guidance assume any price increases that you've taken for this year?

It really does not. That would be much more of an effect for next year, Scott.

But you have -- maybe talk a little about what you have experimented on higher prices so far.

We've done a bit in retail. Maybe Jim will comment as well. In past your quarters, particularly where our inventory position was maybe a little leaner than we had wanted in some product categories, we took the opportunity to test some higher prices here and there and had pretty good consumer reaction to that. So it's been more sporadic. I wouldn't say it's a broad-based program that we've implemented. But it's been more experimentation here and there with positive effects.

And, Scott, evidence of that can best be seen by the fact that our average unit retails, for example, in Carter's was more or less flat, slightly above LY in an incredibly, aggressive and promotional environment. So we have gone out with initial pricing to test the level of price tolerance on the consumer's behalf. And, as a result, we've been able to produce respectable pricing compared to LY. And again, what I think is an aggressive environment as I've seen.

Do you think or I guess, Mike, where do you think the average price increase will come out of that between where you can take it at wholesale, as well as retail?

It's too early to say. The focus of the price increases will begin in spring 2011. What we've asked the merchants to do is pick the spots where they believe those prices will be supported by the consumer. The consumer is strapped. And so, we have both an opportunity and a challenge.

The opportunity is after cost decreasing, at least for our business, for at least the last ten years. We now have an opportunity to test higher price points. In our stores, fortunately 50% of our business is retail. So you have more of an opportunity to test higher price points. But we're going to have to walk these prices up, given where the economy is, where the consumer is.

I don't know if you picked up on Jim's point, but this is probably as promotional an environment as we've seen in recent years. I was out in stores recently. And one of our competitors had a number of racks at $2.99. That's like goodwill store pricing.

So what we're going to have to do is be very thoughtful about where we take these prices up. I think our merchants have a good handle on where those prices will be supported, where we can get paid more, where the retail group has tested higher price points with success. It's going to take us more than one season to raise these prices up to a level comparable to what we're seeing in terms of cost increases.

But on the cost side, Scott, again, the biggest issue we're facing right now are the spikes in cotton prices. And I think the analysis is in the appendix. If you look out over the past ten years, these cotton cycles last some portion of a year. So the cotton prices go down, they go up. And because they go up more cotton is planted and they come back down again.

I'm hopeful that some of these cost pressures are short term. You know if history repeats itself, my guess is this time next year we're going to be talking about significantly better margins for spring 2012 line. But near term it's going to be a challenge.

Okay. Thanks. And then just a couple quick ones. You made a comment that your West Coast stores have started to comp better after delivery of new product. Can you give us the magnitude of those comp improvements or the increases?

Sure. Our product tends to hit from west to east. And in that market, it is meaningful single digit comps coming out of it, upon those deliveries.

The other thing that we've seen, where -- I hate to speak to weather, but we all know the heat wave that has been difficult across the East Coast and a large part of the central region, where weather and temperatures drop a little bit so that mom can get out there with the stroller and the kids, they've also picked up. That's been a component of it as well.

That's a good point. What I'm struck by, I think you know, we segment our stores into different buckets. The traditional drive-to outlet centers we have, which was hardest hit in the second quarter. These are the traditional outlets where you have to drive 30 minutes out to get to them. Open air centers where the moms got to be going from door to door. Those were the hardest hit in the quarter.

By comparison, we have another segment of stores we call Mills stores. These are indoor malls and that was the best performance. Those are the best performing stores. Perhaps a bit different from say adult apparel. With kids' apparel if that mom has one or two children, she's not going to be going out in some of this miserably hot weather.

The encouraging thing to us, as our inventory position has gotten into better shape as we've gotten the new product on the floor, and as the weather has started to ease up a bit in certain parts of the country, we're starting to see some better performance. Carter's is comping up so far in the third quarter. OshKosh I think is kind of flattish. The arrow is pointing up. It's early. We've got one month into the third quarter. But business is improving.

Scott, the other thing that I think is really important to note on this topic, that while, believe me, no one, especially us and myself particularly enjoys negative comps. When we diagnose the business, we're fortunate enough to be able to really dissect our key performance indicators. And the fact that our conversion, traffic to transaction conversion, has remained really healthy, tells me that when the customer comes in, they're transacting, they're buying as healthy level as ever.

And that to me bodes well for the acceptance of the product, acceptance of the brand. And so it really comes down to driving of traffic. Weather didn't help with the traffic side of it. And again, the promotional nature in the space right now, and it's probably all spaces in retail, has been aggressive as ever. And we're having to lean into it very strategically and drive traffic. And learn to more effectively capitalize on the walk by traffic, because the traffic that we communicate directly with, meaning our direct mail and our e-commerce communicated -- or email communicated to customers has been responding at a better rate than ever.

That's great color. Then just last housekeeping, Richard. What's your interest expense assumption for the back half of the year then, after the paydown?

Well, the paydown of the $100 million will save about $1 million or so in the balance of the year. So a bit lower than what we were projecting.

Okay. Thanks, guys.

For our next question we go to Gerrick Johnson with BMO Capital Markets.

Hi, good morning. On your shipment costs, I was wondering what percent of your wholesale business or your mass business as well is done on an FOB basis?

Meaning?

Meaning shipping directly out of the Orient, Wal-Mart say taking possession there and they incurring those shipping costs?

I'd say none of it. What we talk about is in terms of going direct to the customer, very high percentage of the mass channel product goes from Asia to the West Coast, then directly to those customers. But to my knowledge, none of our customers are picking up the product in Asia.

Okay. Great. And online sales. Can you give us a number there?

Yes, Gerrick, at this point it's not material to the Company. We're going to wait and have that business become more significant before we discreetly break that out.

Okay. Understood. All right. Thank you.

You're welcome.

We go next to Anna Andreeva with JPMorgan. Miss Andreeva, your line is open.

Hello. Can you hear me?

Yes, sure can.

Oh, perfect. Sorry about that. Hi, guys. Just trying to also understand the magnitude of EPS decline that you're guiding for the third quarter. Can you maybe talk about what are you expecting for sales growth by quarter in the back half?

On balance, Anna, the strength in the top line will be better in the fourth quarter. I'd say low double digits in Q4 and something more like mid single growth in the third quarter. Recall that third quarter still is under more pressure from the Child of Mine perspective than the fourth quarter will be.

Okay. But specifically in retail, you said the magnitude of shortfall for the back half is coming from retail. You are expecting positive comps for the third quarter as well?

We are.

Okay. And then just looking out to 2011, guess you talked about some of the opportunity to raise prices in retail to offset some of the sourcing pressure. Do you see a similar opportunity in wholesale as well? And just bigger picture, can you maybe talk about some of the supply chain improvements that you guys might be focusing on or, maybe opportunity to move some of the business out of China, given that you have a higher exposure to China than most guys.

In terms of the price increases, keep in mind that the same product that is in our stores is also selling at wholesale. We've discussed the price increases with our wholesale customers for spring 2011 and they're supporting what we have proposed because they're facing similar challenges in terms of what they do with pricing on their own product.

In terms of supply chain, the big initiatives, obviously over 50% of our product is sourced from China. China continues to be the best place to source many of our products, particularly baby. I think I've shared with you in the past, there's at least four things that we look at when we decide where to source our products.

Safety is number one, given the nature of what we do for a living. Quality, reliability, because there are parts of the world you can go and get a lower cost, but not likely to see your product on time. So reliability is very important to us to service our customers. And the other component is cost. So China will continue to be important to us.

With that said, we have been expanding our production in parts of the world like Bangladesh. We've more than tripled our mix production in Bangladesh over the past few years. We've gone to countries like Egypt, which is duty-free, expanding our production in Indonesia. So in words shifting the mix away from China into some lower cost countries, lower cost in some cases does equate with higher risk. But we're managing that risk as best we can with the support of our agents.

I'd say the other big initiative is direct shipping. Direct shipping from Asia to a third party on the West Coast and then directly to our customers. We do that in a significant way with the mass channel, increasing the mix with our wholesale customers. Because over 50% of our business now is being done in our own retail stores, for some of the initial product launches, doing more direct shipping to our stores. To the West Coast, perhaps to a FedEx hub and then directly to our stores, taking out a step in the process. So we've had a good track record of taking costs out of the supply chain. Over the next 12 months, my guess is we're going to see some unusual and hopefully short term pressures on those costs.

Okay. No, that's helpful. So, Mike, the 10% increases in sourcing that you talked about for spring 2011, is that before any offsets or net of offsets?

That would be a gross number, Anna, before the benefit of any price increases.

Okay. Got it.

Just to be clear, that's for spring of 2011 which is the first half of the year. The larger half of our year is in the second half with fall. And by the October earnings call, we'll start to get some visibility on what we think is possible for the second half of next year.

We're hopeful that a lot of these concerns typically get over extrapolated. I'm hopeful that we get a better view on cotton. The most recent reports are that cotton prices are starting to head south. There's also some indication that may also happen with freight costs.

Okay. Thanks. Now that's encouraging. I appreciate it guys.

Thank you.

And for our next question we go to Omar Saad with Credit Suisse.

Thanks. Good morning.

Good morning, Omar.

I wanted to just clarify a couple things in my mind. Maybe I'm just not thinking about it correctly. If I look at the comps in the quarter and I look at the inventory levels and I look at the gross margin. I'm trying to reconcile the fact that gross margins are going up, are pretty strong. But it sounds like -- and inventories, it looked like they're, at least on a total inventory basis, looked like they're okay. But it sounds like maybe inventory shortfall, not having enough in the stores was a hindrance in the comp number. Can you help me kind of reconcile those three different dynamics and make sure I understand what exactly is happening between inventories and comps and gross margins?

Yes. Hi, Omar. It's Jim. I'll do the best I can to help you out there. Again, we break down our comp results into a couple different categories. One is the shift of business from the second quarter into the first quarter, due to the Easter miss. Or the Easter shift. And we'll call that a point or two. And then the other two points we break down into two categories.

One is a traffic decline that we saw throughout the quarter and that decline, however, I think it's important to note, was most severe earlier in the quarter and has begun reversing itself later in the quarter. And that reversal is continuing into July. And then the third component of it is the inventory component of it.

We deliberately and strategically have kept a portion of our open-to-buy in retail to absorb any excess inventories that is available from the wholesale channel. And quite honestly the wholesale channel just performed extremely well and that product wasn't there. So that caused us to have a miss within our total inventory levels. And if you consider when something like that happens, obviously, you sell what you have and it leaves you a deficit and in our case that deficit was most obvious towards the end of the quarter. That was more specifically for the Carter's brand.

On the OshKosh side, the late deliveries that we experienced also left us with an inventory deficit. The first component or a point to two in comp was the shift in Easter and the other point to two in comp, we break down between traffic and the lighter inventories that we had actually planned on having in our stores.

Just to add to that, Jim had made the comment earlier that you're looking at a end of quarter inventory level, Omar. Jim made the comment earlier, that baby, which is a traffic driver for our stores, the average inventory level in our baby component of the Carter's brand was down over 15% in the quarter. So hard to get a comp, a positive comp when your average inventory is -- your highest margin business is down 15%. That's a combination of not enough clearance because of the success of that product offering earlier this year, and new product coming in later in the month of June.

And the baby business, Omar, was the business that was most impacted by the lack of excess. And to just let you know, that as we saw this occurring, to guard against it for the second half of the year, we took the necessary steps to buy the inventory we need so that we don't repeat that issue.

Okay. Great. Yes. Thanks. If I could follow-up, maybe stay on the retail business for a minute. If I think about the comp and perhaps even more importantly the store growth as you guys keep adding stores, how are you thinking about the new store opportunities? Where do we stand on that maturation curve both for Carter's and for OshKosh? And how do you ensure that you're not cannibalizing sales and then there's no comp effect from that standpoint?

Good question, Omar. And I will say that that is the best component of our growth story. The fact that we are at a 467 store business, when you combine both OshKosh and retail, sounds relatively robust. But the fact that the vast majority of those stores continue to exist in the outlet arena, leaves us a very significant green field in front of us for store growth because the Carter's business, for example, only has 118 stores outside of the outlet arena and OshKosh only has 18 stores outside of the outlet arena. And Carter's has been the business that we've worked aggressively to prove out and to feel a high level of confidence in. And we feel very good about that growth model. Our new stores have been performing at and above expectations from a pro forma level perspective. And the nice part about it is they afford us a nice comp performance over a year-over-year basis during their earlier ramp up years. It's a very confident feeling that we have about that model for growth.

Okay. Great. Thanks a lot.

And as a reminder, ladies and gentlemen, that is star one to ask a question. We go next to Susan Sansbury with Miller Tabak.

Oh, yes. Thanks very much. Going back to higher sourcing costs and the margin erosion for the first half of 2011, can you in any way define how large that margin erosion is going to be? And if you were to raise prices to completely offset that, what would be the average price increase?

Susan, I think it's too early to quantify it. We're very early in our 2011 planning. We just felt it appropriate, given the visibility that we've had on the pure product costing side to try and give some insight to the financial community that we think our margins are going to be under pressure. But it's too early to quantify it.

Okay. Within the fourth quarter, the earlier guidance was that that's where the margin erosion would first be felt, in a combination of early shipments of lower margin spring merchandise, as well as product cost increases. Do you have any estimates about what the product cost increase is going to be in the fourth quarter?

I do. Although I don't think I'm going to quantify that either on this call. I would say that component of our margin has remained fairly consistent as we look through the balance of the year. The year-over-year shipments in terms of the just the quantity of spring merchandise we are going to ship in the fourth quarter is roughly comparable year-over-year. There's a modest decline in margin on those products. But we'll give you more insight on that when we actually get into the fourth quarter.

Okay. And then one final question about this competitive environment. I think you described it as being very intense. Can you share any insights into where this pricing or competitive -- can't speak. Promotional activity is coming from, is it mall-based retailers, is it within the wholesale channel?

Sure. Susan, yes, I can definitely reflect on that. And again this is my opinion based on constant study of the retail arena. And it's everywhere. We consider ourselves to be a strong value play without question. When we compare ourselves to last year, we were competing against the smaller balance of competitors that were playing as aggressively as I've seen, we've seen this year. So much of it is mall-based, without question.

I've studied the retail environment and I personally, and I'm sure you guys have been out there as well, have never seen a more aggressive environment within, for example, the malls that I've seen over this past quarter. And the interesting part about it is, it doesn't just lend itself to what you'd consider to be your typical promotional value players. It's everyone. Whether it be a Gap-level business, a Yankee Candle, a Bath and Body Works, an Abercrombie & Fitch, a Hollister, a Children's Place. Everyone that I have seen is playing as aggressively as ever to capture the customer's spend. And we recognize that.

We believe that that is a macro issue that we've got to play incrementally hard against. The good news is we are a value player and we know how to participate in that sport. And when you look at the fact that -- one of the things that I'm most encouraged with has been our database growth. Our database growth it's double compared to what it was last year at this time. And we've been able to utilize that database over the past three years.

Remember Carter's is coming off a 13-quarter run of positive comps, for example. We've been able to grow that data base and utilize that data base very effectively and now it's time for us to turn it up a little bit. So we have invested in the growth of it and now our next step, or the lever we're going to pull is to nail deeper into it. Because of the significant growth of it, we believe there is a lot of very rich opportunity with customers that quite frankly we haven't been and haven't needed to up until now, talked to more as frequently as we will in the second half and go forward business strategy.

Okay. One other sort of follow-on. Price increasing average unit retail is an obvious offset to higher sourcing costs. What about adding more product performance to justify the price increase?

We're focused on making sure we're the best looking product on the floor. Our merchants, with every season study the market. And because we're the market leader, we continue to lead the market. So we're actually happy with our benefits. If you went on the floor today, I think you'll continue to say that our product stands out on the floor. So we're very mindful of what benefits drive the transaction, drive growth, drive unit velocity and where we think we can get paid more for it, we will.

Okay. Just one final point of clarification on lower traffic. This is primarily at your outlet stores. Was that unique to the children's business or was the outlet store business equally as -- was traffic equally as soft to the outlet store center?

I don't know exactly. I do know in the children's space, it has been -- I'd focus on the children's space. In the children's space there's a lot more people fishing within the sea of basically comparable number of fish, compared to LY. That's the way I look at it.

I don't know exactly. I do know that, however, the weather clearly impacted the outlet environment. Again, it's been blistering across the East Coast, as I know you know. And up through the central area of the country. And where we have cool air environments, like our Mills locations, traffic has been better. So I don't know specifically the answer to your question, but that's a little color.

Okay. That's very helpful. I Appreciate it. Thanks so much.

We go next to Howard Tubin with RBC Capital Markets.

Oh, thanks, guys. Maybe just one more question on inventory. Where do you think it will be, kind of on a per foot basis for retail at the end of 3Q and maybe for the total company overall?

I'll speak to the retail piece of it. You know we see ourselves as relatively flat to LY at the end of Q3.

I'd say for the total Company, inventory up in the mid single digit range would be a good planning assumption.

Got it. Okay. Jim, maybe one more question for you on the catalog or catazine. What are the plans for fall I guess maybe relative to last year? Is there a ramp up in mailings this year versus last?

Yes. The key is to impact a meaningful increase in impressions. We're looking at being at least equal with last year on the number of publications or the number of pieces that go out from a calendar perspective. But the quantity per mailing, where we are going to be increasing meaningfully now, we're still looking at that, as I said in my script, we have a plan in place and we are looking at the potential of increasing the quantity. We're currently evaluating our business and looking for any white space that exists within the cadence and making sure we're not missing any opportunities to speak to the customer in a way that will get them out of their homes and into our stores.

Got it. Okay. Thanks.

And, ladies and gentlemen, due to time constraints, our final question will come from Jim Chartier with Monness, Crespi, and Hardt.

Good morning. First question for Jim. Regarding comps to date in July, have you seen traffic increase and have you had to increase promotional activity to date in July to drive that?

Yes. We have seen traffic increase. And we've seen comps improve as well. We are seeing it come from both sides of the equation, traffic and conversion is up. And where we have had sufficient margin, which we have, to be slightly more promotional and to convey a compelling message, we have pulled that trigger. So that's kind of the way we have looked at it, Jim.

Okay. And then for OshKosh, what drove the decision to bring the new product line in later than last year?

That was not a conscious decision; it was a result of just supply chain challenges. And in the industry, it's not isolated to our business that container capacity, vessel capacity, manpower capacity within our factories, within factories in general, has all been a challenge. And it slowed the wheels down a little bit.

Okay. And then as far as the maglog circulation, do you expect to increase that more than you did in first half of this year?

Yes. Yes, we do.

And then for Richard, I was wondering if you could give us some color on what a 1% increase in price will offset in terms of a percentage increase in product costs, given that you'll likely get leverage on other parts of the business and cost structure?

Yes. I think too early to run through that kind of math, Jim. And it would be different by season versus the entire year. So probably more analysis around that and we can probably talk about it as we have a better picture of the full year.

Could you at least give us just some idea of what expenses you do leverage when you take pricing up?

Well, again it varies by business. The wholesale business tends to be more a of fixed cost structure. So every little bit of revenue that you get tends to lever pretty directly to the bottom line, perhaps more so than the retail business, which is a more SG&A intensive structure. So it really would vary by business.

Okay. Thanks.

You're welcome.

And at this time I would like to turn the conference back to over Mr. Casey for any closing remarks.

Okay. Thank you very much. We appreciate you joining us this morning. We look forward to updating you again in October.

And, ladies and gentlemen, this does conclude today's conference. Thank you for your participation.