Carter's Inc (CRI) 2012 Q2 法說會逐字稿

Good day and welcome to Carter's second quarter 2012 earnings conference call. On the call today are Michael Casey, Chief Executive Officer; Richard Westenberger, Executive Vice President and Chief Financial Officer; Jim Petty, President of Retail Stores; and Sean McHugh, Vice President of Investor Relations and Treasury. After today's prepared remarks, we will take questions as time allows.

Carter's issued its second quarter 2012 earnings press release today before the market opened. A copy of the release as well as additional presentation materials for today's earnings conference call have been posted on the company website at www.carters.com. Click on the Investor Relations Sections then News and Events 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 these 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 reconciliation of these non-GAAP financial measurements to the GAAP financial measurements is provided in the Company's earnings release. Also today's call is being recorded.

Now, I would like to turn the call over to Mr. Casey.

Thank you very much. Good morning, everyone. Thanks for joining us on the call. Before we walk you through the presentation on the website, I would like to share some thoughts on our business with you. Over the past few months we have made good progress improving the profitability of our business. We believe the margin pressure from the cotton crisis is now largely behind us, and we are expecting more meaningful margin improvement in the balance of the year. Since our last update we continued to see strong demand for our products in all channels of distribution. We significantly improved our inventory position and cash flow. We acquired one of our sourcing agents in Hong Kong to help us accelerate our direct sourcing initiative.

With respect to our business segments our Carter's business in the United States continues to be the driver of our results. The strength of our Carter's business is the baby product offering, which is the core of the brand, a key component of the baby product line is called Little Layette. This is a high margin replenishment business which we refreshed and relaunched in May and its performance to date has been very good in all channels of distribution. We're on track to open over 60 Carter's stores this year, and our new stores have been achieving their plans. Our retail team has made good progress this year improving the store experience. They have reduced the density of the product on the floor, made the stores easier to shop, and improved the brand presentation.

We recently completed our fall floor set. We have meaningfully improved the "wear-now" component of our fall product line, and third quarter sales are off to a stronger start than last year. Carter's eCommerce sales nearly doubled in the second quarter and its profit contribution more than doubled. All key metrics in eCommerce are better than last year. It is an exciting new growth opportunity for us in both sales and margin contribution. To support the growth we expect this year in eCommerce, we invested in a new multi-channel distribution center in Georgia earlier this year. We expect to begin supporting eCommerce demand from this new facility by the end of the year. By bringing eCommerce fulfillment capabilities in-house we expect to improve our service levels and profit margins. In 2013 we plan to begin supporting the growth in our retail and wholesale businesses with this new facility.

Sales grew 13% in our Carter's wholesale segment in the second quarter. This is very good performance given the current retail environment. In the first half of the year we have had over 10% growth with four out of our top five customers. We met with our largest customers during June market week. A consistent message we heard from our customers in those meetings was that we are doing an excellent job supporting them and driving good performance in their stores with our Carter product offerings. We have a strong cross functional team who focuses on strengthening our brand presentation and performance for the national retailers. Their good work is reflected in these results.

The second largest contributor to our growth in the quarter was our new international segment which represented about 8% of our total sales and 18% of our operating margin. Growth in this high margin segment was driven largely by our new Canadian operations. We expect to open at least 100 stores in Canada over the next five years, and we believe that we have the potential to double our sales and earnings in Canada in that timeframe. We met with some of our largest international business partners in Atlanta in June. Over 40 countries were represented. We are taking a more active approach to manage these relationships exploring with our partners the full potential of their business with us. To better support our international partners we plan to establish distribution capabilities in Hong Kong by the end of this year. Our objective is to leverage our merchandising expertise and stronger supply chain capabilities to help strengthen our brand presence in Asia.

With respect to Oshkosh, we achieved our third consecutive quarter of comp store growth. The growth is being driven by the girls' product offering which is meaningfully better than last year. We have made good progress in improving Oshkosh's product offering. We are getting good feedback from our consumers, retail store employees, and national retail partners. Our back to school offering is now in stores and online. We have improved the in-store experience and marketing to support our second half growth plans. Similar to Carter's we have improved the "wear-now" offering in our fall product line and the third quarter sales are off to a stronger start than last year.

Our focus with Oshkosh continues to be on improving its profitability by strengthening the product offering, editing out unprofitable sales, and improving our supply chain capabilities including direct sourcing and inventory management. Our outlook for Oshkosh is consistent with what we shared with you in April. We are forecasting growth in sales and earnings this year. We expect Oshkosh to grow to at least $500 million in total sales over the next 4 years to 5 years and we believe it has the potential to earn an operating margin of 10% to 12% in that time frame.

In our supply chain we have taken steps to accelerate our direct sourcing initiative and have acquired one of our sourcing agents Chanal Industries based in Hong Kong. Chanal has provided good service to Carters over the past 8 years, and has a very experienced work force that we expect will be very helpful to us. We plan to increase our direct sourcing mix from about 5% today to at least 50% over the next five years. This is an important component of our efforts to improve the competitiveness of our supply chains and increase our profitability.

Given the strong performance in the second quarter we are affirming our previous outlook for the year. We hope to reinvest some portion of the more favorable earnings in our growth initiatives which are focused on leading the market in product value and brand presentation, extending the reach of our brands and improving profitability. As you know our business is heavily weighted to the second half of the year with over 60% of our annual profits forecasted in the balance of the year. I think you would agree this is a less than robust retail market given the sluggish economy which weighs on consumer confidence and demand. That said, we believe we are well positioned to continue weathering the storm. We have a highly engaged talented team of employees focused on achieving our growth plans this year. Richard will now review our second quarter results and our outlook for the balance of the year.

Thank you, Mike. Good morning, everyone. My comments this morning will follow along with the presentation materials which are available on the Investor Relations portion of our website. I will begin on Page 2, with some highlights of the second quarter. Second quarter was very solid for us with significant growth in both our top line and in earnings. We posted strong revenue growth of roughly 20%. This was on top of 21% growth in the second quarter of last year. Our Carter's domestic businesses and international operations drove the revenue growth we experienced in the quarter. Adjusted operating income and adjusted EPS as noted here grew significantly over the prior year. These results were better than we had planned principally due to strong year-over-year gross margin expansion and the contributions from our growth initiatives.

On Page 3 just to orient everyone as to the composition of our business in the second quarter, the chart at the left shows the components of our roughly $470 million in second quarter revenue. As you can see our Carter's domestic businesses represented about 80% of our revenue base, Oshkosh approximately 15%, and international was roughly 8% of the mix. In the waterfall chart at the right you can pretty readily discern the headlines for the change in profitability for the quarter. That is that the Carter's domestic business primarily wholesale drove the increase in year-over-year operating income. International contributed $4 million of the increase, and lower earnings from Oshkosh which were principally due to higher product costs as well as some higher corporate expenses reduced earnings in total by about $7 million. We are pleased by the overall increase in adjusted operating income of over 55%.

On page 4 we provided a more detailed look at our second quarter sales performance. In the U.S. total Carter sales grew over 15%, driven by strong growth in all channels wholesale, retail stores, and eCommerce. In our retail stores comparable store sales increased 1%. Carter's wholesale delivered solid growth of 13% in the second quarter with growth in all brands. Unlike the first quarter off-price channel sales were fairly comparable to a year ago and therefore did not distort the segments top line performance. Consistent with first quarter results we expect a meaningful reduction in off-price channel sales for the second half and for the full year. U.S. Oshkosh sales declined modestly mostly reflecting the effects of retail store closures and lower sales to the off price channel and wholesale partially offset by growth in eCommerce sales.

We have been managing the Oshkosh store portfolio more aggressively over the past year. Focusing on eliminating under performing locations that may contribute to sales but which don't contribute to profitability or in some cases are actually unprofitable. Oshkosh retail store comps grew 1% in the second quarter our third consecutive quarter of positive comps. Our international business contributed approximately $30 million to our net sales growth in the quarter driven by the addition of our Canadian retail and wholesale business. In total our Canadian operations contributed about 8 percentage point of net sales growth in the second quarter. Recall that we acquired this business at the end of the second quarter last year, so beginning in this year's third quarter our results will be on a comparable basis. I will provide some more detail on our business segment results in a moment.

Our second quarter P&L is on page 5. We have already covered the specifics of net sales so turning to gross margin. Second quarter gross margin increases 460 basis points over last year contributing to this increase was our business in Canada and the continued growth in our other high margin direct to consumer businesses namely retail and eCommerce. Our Carter's business drove this major expansion in gross margin due to strong product performance, improved pricing and promotional strategies and in the wholesale side of the business the benefit of lower fall product costs which we began to ship towards the end of the second quarter. Oshkosh gross margins remain under pressure, but we are forecasting good improvement in this metric in the back half of the year when we expect to see the benefit of meaningful lower product costs. Gross margin also benefited from our dramatically improved inventory position year-over-year. Adjusted SG&A increased approximately $34 million over last year, which I will go through in a moment. Royalty income was down versus last year principally reflecting the acquisition of our former licensee in Canada. So on a bottom line basis adjusted earnings per share for the quarter grew over 60% to $0.37.

Page 6 summarizes the key drivers of adjusted SG&A for the second quarter. Our SG&A increases over last year continue to be driven by our growth initiatives namely Canada, retail and eCommerce. As a reminder these direct to consumer businesses are more SG&A intensive than the rest of our portfolio and contributed significantly to our SG&A rate increase. In retail we are operating 46 more stores on a net basis in the U.S. than we did a year ago, and eCommerce volume and associated costs are up meaningfully over the same period. We also are providing for higher levels of performance based compensation versus a year ago given our expectations for improved profitability for the full year. Distribution and freight expensed increased over last year driven by the higher sales volume. Finally the all other bucket contains a number of smaller items including notably spending on brand marketing, information technology, and other corporate administrative expenses.

The next two pages summarize our first half performance. I will touch on just a couple of items on page 7. We delivered very strong first half sales growth of 19%. This reflects nearly 14% growth in our Carter's domestic businesses and our Oshkosh domestic businesses grew about 2%. Our International business increased nearly 4 times driven by our Canadian acquisition. Sales detail by business can be found on page 8.

The success of our growth strategies and pricing, promotional and supply chain initiatives helped us to overcome meaningful product cost increases of approximately 10%. First half adjusted earnings per share increased to 19%, to $0.94 per share compared to $0.79 per share in the first half of last year. Pages 9 and 10 provide detailed reconciliation of our GAAP results to adjusted earnings both for the second quarter and the first half of 2012 and 2011. I encourage you to review these pages to assist in your analysis of our results.

Turning ahead to page 11 we recapped a few key balance sheet and cash flow metrics. Our liquidity and balance sheet remain very strong. Cash on hand at the end of the second quarter was approximately $240 million. A real highlight on this page is that inventories at the end of the quarter declined 18% compared to a year ago with units down 8%. This decline is a result of our inventory management and supply chain initiates and lower fall product costs. The quality of our inventory at the end of the second quarter was excellent. Looking ahead we are forecast year end inventories up mid-single digits in dollars and up low double digits in units versus the end of fiscal 2011 in anticipation of good demand in early 2013. Given our strong cash balance in the quarter and favorable outlook for the year we took the opportunity to pay down $50 million on our revolving credit facility. Cash flow from operations in the first half was $90 million. A first half record for the Company. This is nearly a $180 million improvement from the prior 6 month period reflects our higher level of earnings this year, the decline in inventory, and other favorable movements in working capital.

CapEx for the first half of the year was $38 million compared to $16 million last year. Most of our current year investments relate to domestic and international retail store growth and our new multi-channel distribution center here in Georgia. Page 13 summarizes our business segment performance for the second quarter. Some of these results are presented on an as adjusted basis excluding the impact of the previously described acquisition and facility closure costs. Carter's wholesale segment margins improved nicely compared to a year ago for the reasons I already mentioned. Oshkosh wholesale operating margin performance reflects improved gross margins year over year as the level of off price channel activity has declined. Oshkosh retail profitability has declined due to higher product costs and incremental expenses related to new store openings and investments in the Oshkosh organization and in marketing.

As we have talked about in previous calls the product cost inflation we experienced in playclothes has been severe, the highest of all of our product categories. Despite some very good results in areas like driving higher AURs and improved in store productivity we continue to experienced lower overall profitability in this part of our business. Our forecast reflect our expectations that we will begin to see a reversal of this trend and post earnings growth in Oshkosh retail in the second half. Our International segment margin delivered an adjusted operating margin of nearly 20% compared to approximately 51% last year. Consistent with recent quarters this decline reflects a greater contribution of our Canadian retail stores in the current year compared to a higher mix of royalty income in the prior year. Overall adjusted operating income grew approximately 56% in the second quarter with adjusted operating margin growing by180 basis points to 7.7%.

Now, I will cover second quarter business segment results in some more detail. Turning to Carter's wholesale on page 14. We continue to see good demand for our brands in the wholesale channel. Net sales grew 13% with growth in all Carters brands; Carter's, Child of Mine, Just One You, and Precious Firsts. This net sale growths reflects both unit growth and higher average selling prices. Overall our Spring assortments posted positive over the counter sales despite a somewhat choppy retail environment. Our recent top-to-top meetings with our wholesale customers have been very positive and they continue to reinforce with us the importance of the our brands to their businesses. Seasonal Spring 2013 bookings for Carter's wholesale are planned up about 5% with growth in all brands.

On Page 15 we have some key metrics for our Carter's retail segment. We delivered a comp sales increase in the quarter of 1%, which compared to a strong performance an 8.1% increase last year. We are pleased with our sales results given that we believe some meaningful amount of Spring demand perhaps as much as 2 percentage points of comp growth was pulled forward into the first quarter this year given the earlier Easter holiday and warm weather at the time. The strong appeal of our products coupled with our successful pricing, promotional and inventory management strategies drove a solid increase in AUR for the quarter. During the second quarter we opened 16 Carter stores and closed 3. We ended the second quarter with 385 stores, an increase of 57 stores compared to the second quarter of last year and we are on track to open 63 Carter's stores for the full year. Rounding out the Carter's Retail segment, our eCommerce business continues to perform extremely well. Second quarter sales were approximately $20 million, up $10 million from the second quarter last year. Our growth outlook for eCommerce continues to look strong and we're progressing with plans to in source the distribution center and fulfillment functions of this business later this year.

Now turning to the Oshkosh businesses, beginning with Oshkosh Retail on page 16. Second quarter sales increased about 2 percent in the quarter reflecting growth in eCommerce sales and a slight decrease in retail store sales due primarily to fewer stores in the base. As mentioned previously our Oshkosh retail store have been affected by the closure 13 under performing or low potential stores a year ago and another 5 stores in the first half of this year. Comparable store sales increased 1% for the quarter. As with Carter's Retail, we believe there was a similar effect of demand pull forward into the first quarter. . We continue to be pleased with the improvement in the performance of our retail store assortments. The girl's portion of the business continues to show a lot of momentum in particular.

Our work on a mall store retail concept continues as an important step in bringing the Oshkosh brand closer to the consumer. The three mall stores we have opened have been delivering higher average unit retails and better gross margins than the rest of the chain. We're planning on opening two more mall stores over the balance of 2012, including one here in the metro Atlanta area. As I said earlier, we're expecting improved profitability in Oshkosh retail in the second half of this year.

On page 17, and Oshkosh wholesale. In this smaller part of the Oshkosh business, sales were down 13% in the second quarter mostly due to lower sales through the off-price channel. Regular price Oshkosh wholesale sales, which exclude sales to the off-price channel, declined 4%. We continue to receive good feedback on the improvements in the Oshkosh product assortments. From what visibility we have into our customer's performance, we believe they've been able to successfully raise their AURs based on the product improvements which have been made. Spring 2013 seasonal bookings are planned down about 7% compared to last year, which in part reflects lower up-front selling to off-price channel customers. On a full year basis, we are forecasting Oshkosh Wholesale net sales to decline in the mid-single digits, with a significant decline in off-price channel sales.

On page 18 we've summarized the components of our International segment in the second quarter. . Our Canadian retail stores contributed nearly $27 million to our top line in the quarter. Overall same store sales in Canada for the second quarter declined 6.5%. We believe the pull-forward of demand into the first quarter was more pronounced in Canada than it was in our U.S. stores. Recall that first quarter comps in Canada were up almost 14%. In terms of store format performance the business posted a negative comp in the legacy Bonnie Togs nameplate stores, but a solid to positive comp in the cobranded format. The cobranded Carters and Oshkosh stores are the model we are following for future store expansion in Canada.

During the second quarter we opened 4 new Carter and Oshkosh stores bringing our quarter end total Canadian store count to 73 locations. We plan to open an additional 10 locations in the second half which would bring us to a total of 18 new stores for the year. International wholesale sales grew 45% in the second quarter also principally due to the addition of our Canadian business. In the second quarter we lost our international eCommerce shipping capabilities by partnering with an experienced third party service provider we now have capabilities to serve customers in more than 80 countries. While we aren't planning this to be a material part of our business, we do think it is interesting where demand is coming from. To date, the strongest demand has originated from consumer in Canada, Brazil, Russia, and Japan. International royalty income, which is included in international segments operating income, declined by approximately $1 million versus last year, driven by the acquisition of our former licensee in Canada.

Turning now to our outlook on Page 20. For the third quarter, we're projecting net sales to grow in the mid-single digits over Q3 last year, driven primarily by planned growth in Carter's retail stores, eCommerce, and International. We expect third quarter adjusted earnings per share to increase 25% to 30%, compared to an adjusted $0.67 last year. For the full year, we are reaffirming today our previous full-year guidance which calls for net sales growth in the range of 9% to 11%, and growth in adjusted earnings per share of 20% to 25%. The year is off to a solid start for us and our current second half view reflects some reinvestment of our first half upside in the form of some higher spending on a few key initiatives which we think will position the business well for 2013 and beyond. Notably we are projecting some higher spending in the areas of international, information technology, and distribution infrastructure, and marketing.

I think it is also helpful to remember there is a lot of the year left to play out. As I mentioned on our last call, we continue to monitor risks related to the level of pricing and promotional activity in the marketplace, and we are currently executing a very complex project to transition the fulfillment activities for our eCommerce business to in-house management. We are also cautious regarding the potential for softening demand given the continued weak economy and the uncertain impact of the upcoming presidential election. Importantly, we're continuing to invest in the business in support of our growth initiatives. We're projecting CapEx at in the range of $90 million to $100 million, which reflects ongoing growth in our store base, both here and in Canada, and the initial build out costs related to the new multi-channel distribution center. We expect a solid year of operating cash flow, in the range of $180 million to $200 million.

With that, we are ready to take your questions.

Thank you, sir. (Operator Instructions). And for our first question we go to Robbie Ohmes with Bank of America Merrill Lynch.

Good morning. This is Helena Tse filling in for Robbie.

Good morning.

Good morning. A quick question a couple of quick questions. One, can you discuss the comp trend for the Carter's retail segment through the quarter and also through the trends in July?

Sure, sure. For each of the brands it rolled out as follows. Again on the quarter we were up 1% in each of the brands. We started out in April with the expected shift due to the Easter shift this year. April came in down 3.4%. May rebounded to positive 2.2%, and June was up 3.9% for the Carter's brands. Similar results in Oshkosh. April down 1.9%, May up 6.5%, and June roughly flat again coming in at 1%. The way we look at the quarter as Richard spoke about in his opening comments. We believe there is about a roughly 2% shift into Q1 that would have been realized in Q2 primarily due to the Easter shift and also the unseasonably warm temperatures that we had earlier in this year. Our current comp trend as Mike alluded to pretty much bear that out and we feel as though we are very much on track with our plans.

Great. And then on the AUR trends in the past you have given out pretty detailed segment AUR trends as well as UPT. Would you be able to provide that for the Carter's retail brand and also your wholesale segment?

I would say in general we had good results in all of the key metrics in retail particularly AUR. We decided to pull back a bit on some of that disclosure. We don't think from a competitive perspective it is probably not that advantageous for us to continue to report that. We have continued to make very good progress on pricing.

Got it. Is your wholesale -- can you let us know if the wholesale and retail segment AUR trends are relatively similar like in the past?

I would say we continued to make progress across all of our channels on pricing.

Got it. Then last question would be in terms of your Carter's wholesale segment. Are there shift in the quarter any pull forward from 3Q to 2Q? And maybe elaborate also on any sort of growth initiatives you might have in that segment, whether it is roll out of any planned distribution and the timing of any of that?

I would say the wholesale business has had very strong performance. We have at least a couple of customers working through some issues within their business. To date it has not had any meaningful impact on the business as I shared with you in the opening remarks. Four of our top five customers had growth in excess of 10% in the first half of the year. The business is rock solid. The feedback we continue to get from our wholesale customers is that we are doing a good job for them. I am not aware of meaningful pull forward or shift in demand, I think the performance has generally been good. We are going through a transition now everybody is getting rid of the spring product and the summer product and getting ready for back to school. The timing of the fall floor set varies by retailers. We are probably on the early side. We usually get set early on fall because people based on the nature of the age segment that we are focused in on people buy ahead of need. If you walk in the stores right now you would probably see a lot of good offering of Halloween product and probably within a month you might even see Christmas which we moved up because people are buying beautiful things for their children way ahead of actual need. I would say the wholesale business has been very solid performance so far this year. The outlook is good. The outlook for the business is good for us.

Just to add to that, we didn't really see much of a trend towards demand pull forward. We have in previous quarters had a bit of a phenomenon where customers come to us and ask for product than we had originally planned. That was not significant in the second quarter.

Got it. Thanks, guys.

You are welcome.

And for our next question we go do Susan Anderson with Citi.

Good morning, guys. Congrats on a great quarter.

Thank you.

I was wondering if you could give more color on your guidance. You had a great quarter this quarter, so I am wondering why you didn't raise the year. It seems like you are being very cautious on the back half is that something you are seeing now in the results or are you just taking more of a cautious approach?

I don't know if it so much a cautious approach. We have a good plan for the year. We have good growth plan in both sales and earnings. When you think about what we were up against in the first quarter we had no growth in earnings. For the year we are forecast 20% to 25% growth in earnings. I would read less that we are more cautious than we were three months ago. I just don't feel any compelling desire to every three months be elevating the forecast. As a Company we are focused on executing a very good growth plan for the year. We don't really manage this business from quarter to quarter. You have a lot of moving pieces in our business, multiple channels, multiple brands. If you look at this business from quarter to quarter as opposed to year-over-year on an annual business I encourage you to do the latter because that is the way we manage the business. We have a robust growth plan for this year. We think we have good growth plans for many years to come. We have had a rock solid first half far better than what we envisioned. We have got good growth plans for the balance of the year. I wouldn't read anything into that we are not elevating the forecast. I don't think that is a good practice after three months. Second quarter is probably the least significant quarter of the year. We have two-thirds of our profitability still ahead of us. I would encourage you to think about the kind of growth this Company is positioned to deliver for its shareholders for the year; 10% growth in sales, 20% to 25% growth in earnings. That is a terrific plan, and of course as you know our track record has been we are focused on executing that plan and perhaps doing a bit better than it.

Great. That sounds good. Maybe if you could talk about maybe a little bit more color on taking the eCommerce in-house in terms of the timing and then transitioning to the new DC. I think you mentioned that there should be some margin benefits. I don't know if there are any numbers you could put around it or maybe just a little bit more color.

The big view is the eCommerce business we are well ahead of what we originally laid out a couple years ago as the five year plan. We are probably in year at least three if not year four of in our second full year of doing business online. The consumers clearly love the presentation of both brands online. So we didn't envision we would have to make this investment this year. We thought we would have to make it in years four or five. We scrambled earlier this year. We looked throughout the entire country, we engaged in good outside experts to guide us on where is the best place to have an eCommerce fulfillment center. Thankfully one of the final choices happened to be just north of Atlanta.

We have a beautiful million square foot distribution center about 45 minutes north of Atlanta. We were up there earlier this week. They are making good progress. Product is flowing in, not flowing out yet. We don't think we will be shipping out of that facility until later this year. The margin benefit I would characterize as significant. You pay a very healthy premium to a third-party provider. They have done a good job for us. There is no doubt the third-party fulfillment provider has done a nice job for us but it is time to bring it in house and for Carters the operating margins I am told our forecast we have probably reached somewhere around a 10% operating margin for Carter's eCommerce this year which I think is terrific in its second full year of doing business.

Demand is good, profitability is getting better. We think by making this investment it gives us an opportunity to further improve the operating margin when that new facility gets up and running. This new facility we describe as a multi-channel distribution. Phase one the way things worked out well for us. Phase one of the new facility is to bring eCommerce in. It is the smallest component of our business relative to retail and wholesale. We were briefed earlier this week in terms of the some of the technology that will ultimately go into this facility beginning sometime next year to better support the retail stores and the national retail partners. So I think our service levels in our stores and for our wholesale business I would say is good. I think we will move from good to great over time. We are pretty excited about eCommerce, but particularly this initiative underway with respect to the new distribution center.

Great. That sounds exciting. One last question on the direct sourcing. It seems like maybe you have accelerated that a bit also maybe with the acquisition I was expecting 5% next year but it sounds like you are already doing that. You could talk about the timeframe to reach the 50%, I think five years. Is it more back end loaded or front end. Also with the 5% you are doing now what have been the challenges and what have been the benefits so far?

The high view is substantially everything we have done over the past 10 years has been through sourcing agents, and most of that has been done through Li & Fung the service level from Li & Fung, and the others has been I would say excellent. They helped us achieve a 14% operating margin back in 2010. In terms of the quality of the product, the execution, rarely do we have any issues in terms of delivery. Everyone once in a while if you are sourcing 400 million units you will hit a bump in the road, but I would give Li & Fung and the other sourcing agents a solid A. But it is clear we needed to evolve. It is unusual for the kind of volume we are doing to have substantially everything going through sourcing agents. So over the past year we have developed plans to evolve the business away from agent source to more direct sourcing and the time frame we have set on it is take the time you need. Do it over a five year period. Let's set a goal to at least have a 50/50 mix over the next five years. The overall objective is to create a more competitive supply chain, become a lot more knowledgeable about where good factories are to do some components of our business.

The thing that we are more excited about after we bought Canada, Canada was doing all of their business direct sourcing. Their margins were far better than ours, and their experience in terms of some of the plants they were doing business with we were not, so they introduced us to some good suppliers, but you really can't appreciate it at least based on this conversation the good work that has been put into finding two first class sourcing offices in Hong Kong, the recruiting effort we have had in place over the past year to hire a very talented team that is now in place. The leadership team is in place in Hong Kong. We had some of our new associates from Chanal now our employees here in our office earlier this week. We have contemplated this for some time.

We are announcing today we have acquired a Chanal. We have been working with them for 8 years. They are going to give us a jump start on this effort. We have also been fortunate to have some people here in the United States who have decided to do a tour of duty in Hong Kong nice opportunity for them, so we are not starting with all new people so we can accelerate the effort to get to that 50/50. Again, we say five years, but we just started. As the years go by on every quarter we will give you an update on our progress. I like to think we can accelerate that. For the time being just know that this we view as an important component of our efforts to get back to that 14% operating margin we just earned a couple years ago. Again even that we say might take four or five years. This is a big step forward for us.

Great. Sounds good. Congrats again guys. Thanks.

For our next question we go to Margaret Whitfield with Sterne Agee

Good morning. I was wondering, Mike, if you could comment on the product cost outlook for this fall and next spring and if there is a difference between the play wear, as you described more pressure, than in baby or sleepwear? That is my first question. Thank you.

Sure. The outlook is good and continues to be good. The fall costs for both brands, the mother brands so to speak Carter's and Oshkosh, are down about 10% for fall after going up over 20% last fall. Even though this cost outlook is good, we are still not back to where we were two years ago on the cost scenario. We are starting to get some visibility into Spring 2013. We are encouraged by that. Directionally we think those costs might be down some portion of 10%. It is important to understand the history. In Spring 2011 costs went up about 12%, Spring 2012 they went up another 15% or so depending on what brand, and now they are going down 10%. We are kind of digging out of a hole. We are thrilled with the performance that we are reporting today. Our performance relative to 2010 first half to first half we are kind of still a little bit below what we were earning two years ago. The outlook is good. It is not so much getting that cotton has improved, but other things that we have done over the past year I think are going to be important margin drivers. We talked about one in terms of direct sourcing.

The progress we made in terms of inventory management over the past year I would say has been significant. This initiative that we referred to on earlier calls what we call quick backup. Where we ship into our stores a fraction of what we would have otherwise shipped in. For purposes of this conversation assume we ship in 80% of what we would normally ship in, see what sells, then quickly replenish what sells. So the store is not sitting on a lot of stuff they didn't need. If they have stuff they don't need, they have to mark it down. Our level of clearance sales in our Carter's stores is down meaningfully to last year. Mark downs, excess inventory is lower just as a company, needs to get to the total consolidated view for a moment. Our off-price sales this year we are forecasting they might be half of what they were last year.

In round numbers whatever was $80 million of off-price sales last year will be about $40 million. The losses attached to that will probably be half of what they were last year. We are excited about what is going on with product costs. It is important to know they are still higher than they were a couple years ago. But we have some other things where we have made progress on that we are seeing a meaningful benefit in margin improvement which I think you will see more of in the second half this year.

Well, offsetting the benefits of the product costs and the initiatives you mentioned, I know you are reinvesting in the business. Would you say SG&A as a percent of sales would grow at a similar rate in the back half to what you reported today for Q2?

I think directionally you will see SG&A rise as a percentage of sales. Business is changing. If you look at the percentage of our business that is now direct to the consumer with the acquisition of Canada, with the success of eCommerce, with the success we are seeing in terms of site selection of the Carter stores, the direct to consumer sales a year ago was a little over 50%. This year is closer to 54%. Those business have a different cost structure, but it also has a different gross profit margin structure. If you looked at our business relative to our defined peer group, I would say we probably rank in probably at least the median if not the top quartile in terms of operating margin, but we rank low in gross profit margin and rank low in SG&A.

As our business evolves the gross profit margin will improve and SG&A relative to sales will increase. When you get underneath those numbers, and Richard will be happy to provide more color, it is largely driven by the new Canadian operations, the expansion of our retail, the success of eCommerce. As Richard mentioned we are funding because we can. Some good work on the marketing side of the business. We will tell you more about that in October. Yes, directionally you will see SG&A increase relative to sales.

Final question. I wondered what the acquisition of Chanal and your efforts in Hong Kong means for exploiting the Asian market. I know that was cited earlier as a key focus point apart from Canada and perhaps Brazil down the road.

I think it is an important part of that. We are establishing a management team in Hong Kong to source product and more importantly to support our international partners. I think we have referenced that we are opening a third-party logistics center in Hong Kong, so instead of product going from Asia to Georgia and then back to Asia the product will go from the factories in Asian to Hong Kong and then directly to our Asian based partners. The offices are dual purpose. The near term certainly to support our direct source imitative, but also to be our hub in Asia to do a much better job supporting our international partners and developing a bigger base of business in Asia.

Thank you.

We go next to Howard Tubin with RBC Capital Markets.

This is Courtney in for Howard. I had a question that might apply more to Oshkosh. Do you have any specific marketing plans for back to school, something new or different? Then I know you mentioned that the products had been improving. Can you talk about what has been working and what you would highlight for back to school product wise?

What has been working is girls in Oshkosh. The girls' product offering in recent years had been the weaker component of the offering. Girls' product by its nature is a bit more fashion-forward. It has to have a little bit more bells and whistles on it. A little bit more shine is the word that I hear here in Atlanta. It has to have a lot more beauty to it. The more beauty in it the better it sells. The more basic it is it doesn't sell as well. We have addressed that. We have had good feedback on the Spring line. I think you will start to see this holiday season -- Spring was good and back to school was good and even the holiday product offering you will start to see the improvements we have made in the girls' design. We have beefed up the talent in that component of the business. I would say what is driving the performance right now has been girls. Boys has always been good. Interestingly for Oshkosh B'gosh about half is boys and about half is girls. Right now girls is a little higher percentage of the mix, but boys has always been good and right now girls is out performing boys. In terms of overall marketing effort this is just for all of the efforts that both Carter's and Oshkosh the focus is improve the brands presentation, acquire new customers, and increase the loyalty of the existing customers.

We have made good technology investments in recent years in CRM to help with that effort. I have seen the back to school it is focused on the everyday essentials, it is focused on easy dressing. I think probably the most significant change year-over-year and this is Carter's and Oshkosh is a more wear now offering. That is what the consumer is asking for. If you look at the news, we have a heat wave from coast to coast right now. It was miserably hot up in New England in recent weeks. It is pretty toasty in here in Atlanta right now. That should come as no surprise. It is the summer.

In years past we would have corduroys on the floor right now doesn't make whole lot of sense. Both brands conscionably I think we have set the fall floor set at least a week later than we did last year. If you go in, there is plenty of choices for children shorts. A year ago I would say it was probably tough to find a pair of shorts in our stores today, you have got a lot of wear-now product. It is fresh, it's new, it's bright colors, it's clearly different from Spring and summer offerings which has been discounted and being cleared out.

As Jim referenced our third quarter so far both brands Carter's and Oshkosh in our stores and eCommerce is off to a much stronger start than a year ago. One thing for me to describe our back to school marketing, but one thing I would encourage you to do is get on the mailing list, give us the information so you can get these things directly and you can form your own opinion. I have seen both Carter's and Oshkosh back to school marketing I think it is terrific. I thought last years was good this years is far better.

Thanks a lot. That is all I have.

You're welcome.

For our next we go to Anna Andreeva with FBR Capital Markets.

Thank you so much. Congratulations on nice beat for the quarter. I had a couple of questions. I was hoping to follow up on the gross margin line. You guys obviously saw a nice up side on gross margins. In the first quarter you talked about higher margin ETC, e-commerce, and lower off-price sales contributing the most to that upside. Can you maybe give similar type of comments for the second quarter, and how should we think about the gross margin line into the back half. I was hoping to follow up on Canadian comps. Did you say that Bonnie Togs was comping negatively in 2Q? Just a question on is it pull forward or is there something else going on there? Mike, you always talk about what you guys are seeing in the pricing environment out there. I know you said in department stores your business continued to be very solid in the second quarter. What do you see from the pricing perspective into the back half?

Anna, I will take the Canadian question first. We had a positive comp in the cobranded stores in the second quarter of about 5%. The comp in the Bonnie Togs nameplate stores was down 12%. What we experienced in Canadian was a more significant pull forward of demand in to the first quarter. You had the earlier Easter holiday. The real factor I think was how extraordinarily warm it was for Canada that time of year. More pronounced shift forward of that business. On balance if you look at the first half comps very solid performance. The Bonnie Togs stores were only down about 1.5% that is about $400,000 of revenue most of that actually was outerwear, so in our minds tracks pretty well to the performance we saw in the climate at the time. Very solid performance in the cobranded stores at about 10%. A bit of a shift there. The focus clearly of the business is to continue to build out the cobranded format and that is what we are going to be pursuing going forward.

Your question on gross margin the majority of the upside year-over-year was driven by the Carter's businesses and recall that includes the core Carter's wholesale business, it includes The Child of Mine business, includes Just One Year, - Just One You rather. We have had very good margin performance from a variety of different sources. We have started to ship fall products those costs to Mike's point are down about 10%, so we get a very nice benefit from that. Our inventory position year-over-year is dramatically better than it was a year ago. So the provisions you have to make for excess inventory, for troubled inventory are far lower than they were a year ago.

Then rounding it out I would say would be the very strong contribution of our pricing and promotional efforts in our retail stores where despite facing the higher product costs in the spring assortment we are making more on those sales each day. We have been smarter on promotions and yielding more. So on balance the outlook for gross margin looks good. To your point we will have a continued mixed shift benefit as we move into the second half. The direct to consumer businesses are a bigger proportion of the total the second half. Of course we will have the full benefit of the fall assortments being at lower product costs in the second half as well. So we are bullish on the outlook for gross margins.

In terms of what we are seeing at wholesale generally speaking the pricing is higher year-over-year. It has to be. Everyone's costs went up. Everybody has figured a way to elevate their pricing. It is more than just raising the price. The best price is going to be on product that is selling well. Everybody is focused on strengthening the product offering, strengthening the brand presentation in their stores, making the stores easier to shop. Price clarity I think with our wholesale customers and certainly with us has a big imitative so consumers understand the value in the product offering. The other thing we talked on previous calls is just run leaner on inventory so you are not stuck with a lot of excess goods. That has always been good for pricing and good for margin. Those are some good practices in place with most of our wholesale customers.

Mike, are you planning to keep pricing flattish in the back half?

We are.

And department stores flattish as well?

Yes. The whole strategy with the benefit of the cost reduction in the second half our strategy was to maintain the level of pricing that we had in the second half of 2011. That is correct.

Great. Thank you so much. Good luck for the back half.

Thank you very much.

We go next to Susan Sansbury with Miller Tabak.

Thank you very much. Everybody has asked most of the questions, but, Mike, kudos for getting all of this momentum going. The up side seems to be enormous. In that regard talking about this return to the 14% plus pre-tax margin, is it too soon to shorten the timeframe in which you might accomplish that objective?

Yes. First thank you, and, second, yes, too soon. A lot of these things are still evolving. If you look at over the next four to five years and knowing that everybody here if there is one number that most people that are in this Company, particularly people who support me know is that 14%. We are working hard to get back to that. If you look at the business in 2010 versus where we are today, it is a much different business. We have Canada, we have a wonderful eCommerce business, we have a bigger presence with our stores, we are making some good investments in the supply chain, we are making good progress with inventory management discipline. I think it is a far better Company today than it was in 2010.

In 2010 we achieved our record level of performance. We are determined to get back to that, but things take time. As Richard said before we are going to continue to invest. We are not going to ring every nickel of opportunities out of this business this year. We are performing well. We are going to use some of the upside to reinvest into some of these good growth initiatives. We are starting to focus more on 2013 and 2014 now, and making sure we position ourselves well as we roll into next year. So yes I would say too early to accelerate that timeframe. Even if it does take us four or five years to get there, we will deliver good performance for our shareholders.

No, it is exciting. Any feedback you can provide from the gathering of all of your licensing partners in Atlanta? Is there any update in terms of your franchising initiatives or bringing anybody in-house?

For me it was something to say and this has been an area of focus over the past couple or few years. We always had an established business in international markets it just didn't get a whole lot of attention. It has a tremendous amount of attention right now. We brought these folks in. We had a big sales meeting over the weekend here back in June. As these folks stood up and introduced themselves. I was struck by the number of countries represented. We had over 40 countries represented at this meeting. As they stood and introduced themselves I asked how long had they been doing business with us. A number of people five, seven, ten years. Some people were 15, 20.

One fellow 25 years who represents our brand in the Middle East. What a wonderful opportunity to now work with these folks to say what is the full potential of your business with us? With our wonderful resources and their local market expertise, what can we do together? Our vision here for our Company is to be the world's favorite brands in young children's apparel. We are the market leader in the United States. We own 17% share of a $22 billion market. Nobody is even close. We own 3 times the share of the nearest competitor. If you look at the earliest ages newborns to 24 months we hold 5 times the share of the nearest competitor.

If you look outside of the United States and you take the top five markets it is at least equal to the size of the market in the United States. We own probably less than 1% share of the collective market outside of the United States. Our near term focus is on China and Japan. That is where the market is. The other markets South Korea, Mexico, Australia those market sizes pale in comparison to China and Japan. We are devoting some attention to that. As those things take shape we will share it with you. We are trying to replicate this wonderful model that has been built over many years in the United States which has a retail component, wholesale component, licensing and eCommerce.

All of those things exist today outside of the United States. It is just what is the full potential of each of those business components? We have a search underway. Probably the only gap I would say we have of any significance in our organization is full time executive over international. We have been interviewing for that position over the past few months, and we are seeing some very talented people and I hope we have more to share with you next time we have our update.

That sounds great. Best of luck for the back half and beyond.

Thanks, Susan.

All right. Good bye.

Bye.

We go next to Scott Krasik with BB&T Capital Markets.

Hi, thank you for taking my question. Question on the sales guidance. It sounds like all your direct business are off to a really good start in the third quarter. You said you were going to get probably flat pricing in your wholesale business. How are you thinking about the wholesale business for the back half of the year? It would imply to me that maybe you are thinking about those being flat to down.

A significant factor, Scott, continues to be the decline in off-price activity. That will affect our reported wholesale numbers in the second half. Absent that we are forecasting good continued growth in the what we call the regular price portion of the business.

Okay. So you wouldn't label it conservative because the off-price is coming out?

I think we continue to have nice momentum in the core part of the wholesale business. The decrease in off-price inventory tracks directly to our improved inventory position. I wouldn't look at our reported number as the exact barometer on the health of the business. I think we are in better shape today than we were a year ago because we are not liquidating inventory.

Jim, historically you guys had a bit of a traffic problem. The weather would get very hot people would stay away from the outlets, but you said that your comps quarter to date are positive. Are you not seeing that phenomenon at this point?

It is earlier in the year with the shift traffic came in the first quarter. A little bit of decline in the second quarter as a result of that. We are very happy right now, however, with our overall performance especially in the brand stores. We have 209 brand stores right now, Scott that are close to where mom lives and are convenient. We like to think we position these stores in their shopping destination of choice. So as a result that is helping us to offset what in the past may have been more of a concern from a traffic perspective in the hot weather decline and causing people not to go out to our outlets. Overall we feel we are able to meet the customers' needs with the incremental locations.

We also have a couple initiatives underway that are assisting with this and we don't talk much about it, but we have begun remodeling some of our stores. Interestingly enough, the remodels of which we have got about 33 done to date are also seeing incremental upside in sales. In a large part due to traffic. We have been able to go into some of our stores, you have been in them, and we have moved our cash wrap out of the center of the store. More effectively utilized the overall square footage and picked up capacity and those stores have actually seen an uptick in our traffic. It ebbs and flows a little bit with the peaks and valleys of the hot weather, but the beauty of this business is that these children basically grow out of their wardrobe every three months and they have to go back out and get more. With our brand store strategy meets mom's need, so we are in good shape.

Mike, you mentioned you are holding pricing flat at wholesale right now. Is that assuming pricing flat for Spring of '13 in your discussions as well?

That is correct. Yes. The pricing for spring '13 will be comparable to spring '12.

Okay, great. If I am looking at your sort of peak core quarter gross margin performance you look at the second half of 2009 to the first half of 2010 you did about 39.5%. To your point you have mix in your favor, costs are going to keep coming down even more, is there any reason to think that you can't be above that or significantly above that?

I think long-term we certainly have the potential to get back to that territory, Scott. I don't see any barriers. We have a lot of wind in our sales from a gross margin perspective.

To get to that. I think you will be there in the next couple quarters. In terms of exceeding that for 2013 would that be the goal to exceed past peak margins, or to reach them?

The goal is to work our way back to that 14%. I think less about gross profit margin. You have got to look at operating margin. The business is changing. The thing that is important to us is how do we work our way back to the 14% operating margin? I think that is the key metric that we will work hard to show progress with.

Okay. And then just lastly, Richard, I know you are investing in the business but the cash flow profile still looks really strong. Any reason why you are not buying stock back here if you think the margins are going to keep going up.

We consider a range of alternatives for our cash. Scott, I would say we are in an aggressive period of evaluation of how we put the cash back to work in our business. I would rather see if we can't accelerate our growth and use it for that purpose. If we really find ourselves in a position of true excess cash that is really where the debate is how do you define excess? It is not our intention to hold onto it forever.

Okay. You don't view yourselves as having excess cash to do that right now?

I think we are still in the period of evaluating it. There are a number of opportunities that could be potentially attractive for our business. I think International is a good case study where I don't think we have fully scoped how we can take these great brands and take them overseas in more meaningful way and we would like to accelerate that and that likely has some cash implications.

All right. Thanks guys, and good luck.

Thanks, Scott.

We go next to Jim Chartier with Monness, Crespi & Hardt.

Good morning. Thanks for taking my question. Two quick questions. First, what do Oshkosh bookings look like for spring next year excluding the off-price?

I would say down slightly, Jim.

Then is there any impact on second half earnings from the acquisition of the sourcing agent?

There is not. It is actually a Q3 transaction for us and it very immaterial to the consolidated results for the Company, so we have not disclosed terms of that transaction.

Thank you and best of luck.

Thanks, Jim.

We go next to Gerrick Johnson with BMO Capital Markets.

Hi, good morning. You mentioned you are keeping your pricing flat in the back half is that based on anticipation that competitors will do the same?

I don't know what the competitors are going to do. We have studied the market. We see what are competitors are doing. It is based on our best judgment. We are the leader in the market, so I like to think what we do, others follow. It is based on what our pricing strategy has been determined to be based on what we think will move our brands forward. The reality of it is we don't know what our competitors are going to do in the second half. We have enough history of setting prices that we think we will be well positioned in the market. Our overall focus is to make sure we are providing great value to the consumer.

Okay. Given that you are not providing the numbers of transaction or the units per transaction at retail can you at least tell us if the number of transactions were up or down in the quarter?

Number of transactions on the quarter on a comparable store bases were down slightly, but the quality of transaction was much more significant. The stores in large part due to the quality of product have done a really nice job in conversion. Conversion is up. Our conversion numbers to begin with which is obviously transactions to traffic our conversion rate is record high in the industry to begin with and on a quarter and year-to-date basis we have seen nice improvement in that conversion rate overall. That tells me the customer is boding very positively around the assortment. I think and Mike alluded to it earlier, but I don't think we can underestimate the importance of improving the overall shopping environment has done.

We deliberately exited from our store a number of fixtures. Approximately 10 in a large percentage of our stores and created a much more shopable experience and positive response from the customers has been significant so all of this has allowed us to focus on more profitable product more desirable product and the overall quality of the transaction has seen upside as a result of it. While the traffic or transaction is down slightly, overall quality of transaction has been meaningfully improved. That is I think if best way to run one of these businesses. It has also helped us to realize a less significant clearance side of the business which has helped overall average unit retail. The initiatives that we have put in place have been really in a large part about an incremental gross margin quality per unit. They have not only begun paying us back this year but they have long-term sustainable benefits to them.

Great, thanks. That is a great detail, Jim. Lastly just one strategic kind of question. I know the mall based store initiative is relatively young, but do these malls you are going into have anchors like JCPenney or Macy's, et cetera that might already have your product or are you trying to avoiding malls with those kind of anchors?

No, we are going to pursue where the best real estate is. So keep in mind the wholesale component of Oshkosh is very small. We are not avoiding any location. The overall objective with this component of our Oshkosh initiative is simply to bring the brand closer to the consumer. The brand got very high marks last year when there was a survey done with consumers of what brands they rank highest in the outlet centers Oshkosh and Carter's scored very high in quality, value, selection, service. What we are trying to do is just add another dimension to this convenience. So no some of these malls may have some of our very good wholesale customers.

I don't think it is going to be an issue whatsoever with respect to Oshkosh. Given it is becoming one of the smaller components still important but it is one of smaller components of the business. I think near term the focus for Oshkosh should still continue to be on the outlet stores that is where the lion's share of the revenue is and even as we look out over the next four or five years the lion share of the profitability is going to be coming out of the existing business we have today. The first real mall store we will have will be in the Mall of Georgia sometime here in September. I would encourage you to come see it. We will have another one in Houston Galleria later this year. But it is relative to the total Oshkosh franchise it is the smallest component of the business near term. I would view it as R&D. We are trying to make the brands to be more convenient, elevate the experience have it be a more special product offering for the consumer and create another growth vehicle for the brand.

Fantastic, great. Thanks a lot, guys.

Thank you.

With that, ladies and gentlemen we have no further questions on our roster. Therefore, Mr. Casey, I will turn the conference back over to you for any closing remarks.

Thank you all for joining us this morning. Your questions are very helpful to us. We hope this briefing has been helpful to you. We look forward to updating you on our progress in October. Good-bye.

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