Carter's Inc (CRI) 2014 Q2 法說會逐字稿

Good day everyone, and welcome to Carter's second quarter 2014 earnings conference call. On the call today are Michael Casey, Chairman and Chief Executive Officer, Richard Westenberger, Executive Vice President and Chief Financial Officer, Brian Lynch, President, and Sean McHugh, Vice President and Treasurer. After today's prepared remarks, we will take questions as time allows. Carter's issued its second quarter 2014 earnings press release earlier this morning, a copy of the release and presentation materials for today's call have been posted on the Investor Relations section of the Company's website at www.carters.com.

Before we begin, let me remind you that statements made on this conference call and in the Company's presentation materials about the Company's outlook, plans, and future performance, are forward-looking statements. Actual results may differ materially from those projected. For a 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 presentation materials. Also, today's call is being recorded. And now I would like to turn the call over to Mr. Casey.

Thanks very much. Good morning everyone. Thank you for joining us on the call. Before we walk you through the presentation on our website, I would like to share some thoughts on our business with you. We continue to make good progress with our growth initiatives this year. In the second quarter we exceeded our sales and earnings goals. We achieved our pricing objectives, improved our gross margin, leveraged SG&A, and gained market share. Given our strong first half performance, we are raising our earnings guidance for the year.

As a reminder, we are focused on three key priorities for our business. The first is to provide the best value and experience in young children's apparel. The second is to extend the reach of our brands, and the third is to improve profitability. We continue to receive high marks from consumers on the strength of our brands. In a recent survey, good value was one of the top brand attributes cited by consumers, together with stylish clothing and helpful store associates. In this economy, value is very important to the consumer. Year-over-year I would say the market was more promotional in the second quarter. Many retailers were moving aggressively through product that backed up due to the cold weather earlier this year.

Despite the more promotional environment, we improved our price realization in the second quarter given the strength of our product offerings and inventory management initiatives. We were very thoughtful in setting prices this year to help offset higher product costs. We believe we are competitively priced and expect to achieve our price objectives in the balance of the year. July sales were off to a good start. The big months for us this quarter are August and September, driven by the Back to School shoppers and Labor Day holiday. We had a good back to school period last year, and plan to build on that performance this year.

With respect to brand experience, we have the broadest distribution of young children's apparel in the United States. Our objective is to have a beautiful presentation of our brands wherever consumers are shopping for children's apparel. Our fall floor sets will be completed within the week. We have strengthened our Back to School marketing and product offerings with more transitional wear now apparel. I would encourage you to visit our stores this fall to see the strength of our product offerings and in-store marketing. We're also making good investments with our wholesale partners in brand presentation, including a new Carter's shop at Macy's Herald Square scheduled to be completed before the holidays this year.

With respect to extending the reach of our brands, we plan to open over 100 stores in North America this year, including 22 stores in Canada. We continue to be pleased with the performance of our new side-by-side store initiative, and plan to open 24 of these stores this year. We believe consumers enjoy the convenience of shopping for both brands in one location. These stores provide a complementary product offering, serving the needs of a newborn to a 10-year-old child. These combined stores are expected to generate about $2 million a year in sales, with good margins. We believe we can open 200 or more of these stores by 2018.

With respect to our eCommerce business, we continue to see strong demand in the quarter. The online channel is the number one way consumers connect with our brands, and we are planning higher investments in digital marketing this year. We're leveraging our expanded eCommerce capabilities to reach more consumers, and engage them more effectively. We completed the in-sourcing of our eCommerce call center in the second quarter. We believe this initiative will enable us to provide a higher level of service to our customers, and further improve the profitability of our eCommerce business.

Earlier this month, we launched our new eCommerce business in Canada. You can visit the website at CartersOshKosh. CA. We expect this new growth initiative will make shopping for our brands more convenient for Canadians. We believe our new website may contribute as much as $30 million in sales or 10% of our projected Canadian store sales by 2018. As we've shared with you previously, over 40% of the demand on our US website is coming from international customers. The highest demand in the second quarter came from Brazil and China. Online demand in China nearly tripled in the second quarter. Given this experience we are exploring the opportunity to launch eCommerce capabilities in other parts of the world. As you may know, China is expected to surpass the United States in online shopping transactions next year. In a recent McKinsey study, clothing and footwear were ranked as the most likely categories to be purchased by Chinese consumers online. Given the level of demonstrated demand outside of the United States, we are allocating more resources to pursue opportunities in China.

With respect to improving profitability, we expect to make good progress this year improving our operating margin. We believe the drivers of this margin improvement will include a higher mix of retail and eCommerce sales, more efficient distribution capabilities, a higher mix of direct sourcing, and the improved performance of our OshKosh brand. Our new distribution center has continued to ramp up to support the increased demand from our multichannel customers, and we're expecting good leverage of our distribution expenses in the balance of the year. Our supply chain performance in the first half was meaningfully better than last year in terms of on time deliveries and quality.

We now have visibility on spring 2015 product costs. Our merchandising, design and supply chain teams have developed a strong product line for spring 2015, with better product benefits, more wear-now choices and better estimated margins. Given the favorable trends in cotton prices, we believe it's possible that we may be in a more stable cost environment than we've experienced over the past year. Rising labor costs in Asia are still a challenge, but we're currently forecasting slightly better margins for the first half of 2015.

In summary, we believe we've made good progress in the first half, strengthening our business, and expect to achieve our growth objectives this year. In the balance of the year, we will continue to focus on leading the market in product innovation, executing our side-by-side store initiative, improving our supply chain capabilities, leveraging SG&A, and improving our operating margin. I want to thank our employees throughout the Company who helped us achieve the strong results we are reporting this morning. I am grateful for their passion for our brands, and their commitment to help us execute our growth plan this year.

Richard will now walk us through the presentation on our website.

Thank you, Mike. Good morning everyone. I will highlight our second quarter and year-to-date results, and then cover our expectations for the third quarter and the balance of the year. As usual it is helpful to have a copy of our presentation materials alongside as you listen to my comments, and these presentation materials are available on our website. Note that my comments on our business performance are on an as-adjusted basis, a reconciliation to our GAAP results is provided in the Appendix of today's presentation.

I'll start on page two with some overall highlights of the second quarter. As Mike noted, we had a terrific second quarter, we delivered strong growth in both topline sales and in earnings. All business segments contributed to our sales growth of 11%, and we posted comp store sales increases across all of our retail store businesses. Carter's and Oshkosh in the US and in Canada. Higher sales improved gross margin and expense leverage drove earnings growth of 33% to $0.61 per share. We outperformed our prior guidance principally due to better than anticipated gross margin and spending favorability, a portion of which we would attribute to timing. Page three highlights the drivers of our sales growth in the second quarter. Total Carter's sales in the US grew 10%. Our retail stores and eCommerce businesses were each significant contributors to this growth. Overall our Carter's direct-to-consumer comp increased nearly 8%. Carter's wholesale grew in the low-single digits.

Our US OshKosh businesses delivered a very strong quarter. Total OshKosh sales in the US grew by 17%, and our direct-to-consumer comp increased 11.6%. Second quarter international segment sales grew 13%, driven by wholesale demand across multiple markets, and growth in our retail store business in Canada. The devaluation of the Canadian dollar compared to the US dollar negatively affected segment net sales by approximately $3 million in the quarter. On a constant currency basis international segment sales increased 18% over a year ago. I will discuss our business segment results in more detail in a moment.

Moving on to page four in our second quarter P&L. Consolidated gross margin in the second quarter was 42.8%, up 30 basis points to last year, which was a bit better than we had planned, in part due to stronger margins in OshKosh retail. The improvement compared to last year reflects growth in our direct-to-consumer businesses, and lower spending, including lower air freight expense. These factors offset the headwinds of higher product costs and unfavorable foreign exchange movements. Overall we saw a narrowing of the gap between product cost and pricing in the second quarter which benefited our gross margin performance. Adjusted SG&A was 33.9% of net sales with good leverage versus last year. These results were better than we had planned.

Adjusted operating income grew 31% in the second quarter and adjusted operating margin improved by 150 basis points to 10.2%. Second quarter average share count was approximately 10% lower than a year ago, driven by our meaningful share repurchase activity over the past year. Share repurchases net of higher interest expense associated with last year's debt financing had a roughly neutral effect on EPS in the second quarter. So again, all of this nets to adjusted earnings per share of $0.61 for the second quarter, an increase of 33% compared to the adjusted $0.46 a year ago.

Now turning to page five, and a recap of spending in the second quarter. Adjusted SG&A increased 7% to $195 million, leveraging 140 basis points on a consolidated basis compared to the second quarter of last year. These results were better than we had anticipated in part due to approximately $3 million of favorable timing of spending. Direct-to-consumer expenses which include retail four-wall expenses and eCommerce fulfillment costs increased by $14 million, once again representing the largest component of the overall increase in SG&A versus last year. While we leveraged comparable store expenses, overall expenses are higher due to new store growth, nearly 100 more stores in the US and Canada than a year ago, and due to this tremendous growth of our eCommerce business in the US. Depreciation increased by approximately $3 million in the second quarter reflecting growth in infrastructure investments in areas such as retail stores, supply chain facilities, and information technology. The wind-down of our operations in Japan which were largely completed earlier this year contributed $4 million in favorability and spending compared to last year.

Distribution and freight expenses in the second quarter were comparable to last year despite good unit volume growth. We're beginning to see the benefits of the greater automation and technology in our new Braselton, Georgia distribution center, and expect to more fully leverage this center's capabilities in the second half. Managing SG&A remains one of our top priorities. We continue to forecast that we will leverage SG&A in the second half and for the full year. Pages six and seven summarize our first half performance. We've had a very good first half particularly considering the tough first quarter in the terms of weather disruptions and the challenging retail environment. Year-to-date net sales increased 11% and adjusted EPS was up 7%. We think we're well-positioned for good growth in the second half of this year.

Now turning to the balance sheet and cash flow highlights on page eight. Our balance sheet and liquidity remain very strong. We ended the second quarter with $208 million in cash, and have an additional $181 million of availability on our revolver. Quarter end inventories increased 25% in dollars versus a year ago, with units up 17%, both in line with our forecast. About $35 million of our ending inventory balance represents product receipts brought in early in anticipation of a potential West Coast port strike. Additional drivers of our higher inventory include higher product costs, business growth and improved factory performance, which has improved our on hand position relative to a year ago. We're projecting inventory growth to moderate over the balance of the year, with third quarter ending inventories expected up over last year in the high-teens range, and year-end inventories forecasted to increase in the low-double digits, closer to our targeted sales growth.

We've made a lot of progress on our open market share repurchase program in the second quarter, by buying back approximately 0.5 million shares for $34 million. Over the last four quarters we've returned over $450 million to shareholders in the form of share repurchases. Our year-to-date open market repurchases have totaled approximately $51 million, or about 700,000 shares, and we have approximately $216 million remaining under our Board repurchase authorizations. We've summarized some additional information on this page regarding cash flow and CapEx, we're expecting another good year of operating cash flow, which is funding continued investment in the business to support our future growth. On page 10 we summarized our business segment results for the second quarter. Overall our consolidated adjusted operating income grew 31% to $59 million, an increase of $14 million over last year.

Our consolidated adjusted operating margin increased 150 basis points to 10.2%. Improved profitability in our Carter's and OshKosh retail segments and lower corporate expenses drove this consolidated margin improvement. I will cover the individual business performance in more detail starting with Carter's wholesale on page 11. Carter's wholesale net sales grew 2% in the second quarter, and our major national customers season to date spring 2014 over-the-counter selling was up modestly with improved AURs. Segment operating margin declined 70 basis points, principally due to higher product costs that weren't fully offset by pricing improvements. For the full year we expect that Carter's wholesale segment net sales will grow in the low-single digit range.

Looking ahead to next year our spring 2015 seasonal bookings are expected to be comparable to this year. In general we are seeing increased caution regarding commitments across our wholesale customer base, given what's turned out to be a pretty challenging spring season across the industry. Our general planning assumptions for the Carter's wholesale segment is for low single-digit revenue growth. That would be our objective for 2015. It is worth noting that we have a nice portion of this business which is replenishment based, which can often even out shorter term swings in seasonal product bookings. Maintaining an innovating compelling brand presentation at wholesale remains one of our priorities. On page 12 we have included a photo of a Carter's baby shop at Kohl's. We rolled out these baby shops in nearly 800 locations last year to strengthen the presentation of our signature zero to 24 month products, and the results to date of these shops has been very good.

Turning to page 13 and the Carter's retail segment. Total US retail segment sales increased 17% versus last year, driven by the addition of 71 net new stores, and an increase in direct-to-consumer comparable sales of nearly 8%. Retail store comp sales increased 3% in the second quarter reflecting higher transaction counts and improved AURs. All regions comped positively except for the Southeast. In terms of product performance, boys playwear, baby and swimwear drove the retail store comp improvement. We opened 20 new stores in the second quarter and closed two. New stores including Carter's stores opened in our new side-by-side configuration with OshKosh continued to perform well and in line with our expectations.

For the full year we expect to open approximately 60 new Carter stores in the US. Within the Carter's retail segment eCommerce sales grew 36% over last year, and profitability improved as well. Carter's retail segment profits grew 21%, and segment operating margin improved by 50 basis points, reflecting an increased eCommerce contribution and comp store expense leverage, which more than offset the impact of new store openings. On pages 14 and 15 we have included photos of new Carter's stores in Brooklyn and Jackson Heights, New York. These are good examples of opportunities we see to bring the brand closer to the consumer in street locations with significant population density. These stores are new to the portfolio but they are each off to a strong start.

Turning to the OshKosh retail segment on page 16. OshKosh delivered another very good quarter. Segment sales increased 20% versus last year, driven by the addition of 23 net new stores, in addition to strong brick and mortar comp store sales and excellent eCommerce sales growth. Our total direct-to-consumer comparable sales increased nearly 12%, reflecting eCommerce sales growth of 43%, and a retail store comp increase of 7%. We saw a nice increase in average transaction value with improved AURs in OshKosh in the quarter. All regions and all store types comped positively in the quarter, and additionally all product categories comped positively. Girls playwear and accessories were the strongest drivers of our retail store comp growth this quarter.

During the quarter we opened four new stores and closed three. All new stores were in the side-by-side format. As Mike said, we believe customers are responding well to the convenience of this new format. We also believe that we are reintroducing the OshKosh brand to consumers, which has been one of our key objectives. Nearly 60% of OshKosh customers in these new locations have not shopped the brand in the last 12 months. The operating loss to the OshKosh retail segment improved nicely this quarter due to strong product performance and expense leverage. We are forecasting that 2014 will be a good year in terms of improving the total profitability of the OshKosh brand. The next three pages include photos of several of our new side-by-side stores in Georgia, Minnesota, and Texas. Hopefully many of you will have a chance to visit one of our new side-by-side stores and share your feedback with us. OshKosh wholesale second quarter performance is summarized on Page 20. Second quarter net sales grew 3% which was consistent with our forecast.

Segment operating income increased by approximately $1 million. Spring seasonal bookings for 2015 are planned down in the high single-digit range, reflecting again, we think the conservative planning posture of our wholesale customers based on spring performance this year. We continue to work with our wholesale partners to enhance the presentation of the OshKosh brand at wholesale, and to offer a very targeted and productive assortments to our customers. It is our belief, though, that the majority of near term growth in OshKosh will come from our direct-to-consumer businesses.

Now turning to our international segment on Page 21. International segment net sales increased 13% over last year, driven by wholesale sales growth in Canada and other markets, in addition to higher sales from our Canadian retail stores. Negative foreign currency translation affected second quarter international segment net sales by approximately $3 million. The operating income impact of negative FX translation in the quarter was approximately $0.5 million. International segment retail store sales in the second quarter were comparable to last year, as growth in our Canadian retail business was offset by the exit of our Japanese retail business earlier this year.

Canadian retail revenues increased 15% in US dollars reflecting the addition of 19 new stores versus a year ago, along with an increase in comparable store sales. The 3% comp reflects good growth in sales of Carter's and OshKosh branded products in the quarter. In the case of OshKosh about an 18% increase. Offsetting these increases has been lower sales of the legacy private label brands in our Canadian stores, and we've now completed the exit of those private label brands within the stores in Canada. In the second quarter we opened seven stores in Canada bringing our quarter end Canadian store count to 110. Also in the second quarter, we completed the conversion of the 28 legacy Bonnie Togs store nameplates to the co-branded Carter's and OshKosh name.

The development of our multichannel business model in Canada reached an important milestone last week with the launch of our eCommerce site. The launch of this new business has been a great collaborative effort across our US and Canadian teams. Second quarter international segment adjusted operating margin declined 110 basis points compared to last year to 13.1%. This decline is the result of higher product costs in Canada, driven by unfavorable movement in exchange rates, partially offset by the favorable comparison to last year, which included an operating loss in Japan.

On page 22 we've included a shot of the new Canadian website launch page. We encourage you to take a look at the website when you have a chance. On page 23 we've included a photo of a new Carter's and OshKosh co-branded store in Melbourne, Australia. Our partner in Australia operates five such stores in this market. We think this is another great example of the power of the Carter's and OshKosh brands presented together in a single retail location.

Now turning to our outlook on page 24, for the third quarter we're projecting net sales to grow approximately 4% to 6%, driven by the Carter's retail, OshKosh retail, and international segments. Carter's wholesale net sales are forecasted to decline in the mid-single digit range in the third quarter, and this is consistent with our forecast of low-single digit net sales growth for the full year. The third quarter is expected to be affected by reduced shipments to a particular wholesale customer as we've described on a previous quarterly call. We expect third quarter adjusted earnings per share to increase approximately 7% to 10% compared to last year's adjusted $1.12 per share. For the full year we are reaffirming our previous guidance for net sales and raising our earnings guidance. Net sales for 2014 are expected to grow approximately 8% to 10%. We now expect full year adjusted earnings per share growth in the range of 14% to 16% over adjusted earnings of $3.37 in 2013, an improvement over our previous outlook for this year's profitability.

As noted earlier, we continue to forecast good operating cash flow for the year in the range of $200 million to $250 million. We're maintaining an appropriate level of caution on the balance of the year due to several key risks. These include the overall macroeconomic environment, and a heightened level of promotional activity in the marketplace, which could affect our pricing and promotional strategies. We're also monitoring movements in the Canadian dollar and the progress of the ongoing labor contract discussions involving West Coast ports. And finally, the successful transition and ramp up of our new multichannel distribution center is a key operational objective over the balance of the year.

With these remarks, we're ready to take your questions.

Thank you, sir. (Operator Instructions). And we will pause for just a moment to allow everyone the opportunity to signal for a question. And for our first question we go to Steph Wissink with Piper Jaffray.

Hi, good morning everyone, thank you for taking our questions. Just a couple of quick ones. I'd love to hear a little bit more about the eCommerce growth in the quarter. It was is very strong. Are you seeing any changes in your consumer adoption or any new entrants to the brand in that channel, and how do you think about mobile as a portion of the eCommerce driver? And then secondly on the Canadian stores, some nice lift there in terms of the overall productivity. If you could talking about more about what you're seeing from a four-wall basis versus the US, that would be helpful. And then just lastly, I think that you mentioned at the end your prepared remarks, the reduced shipments to one of your key wholesale partners in the third quarter impacting the guidance. Could you just talk a little bit more about the volatility and the order cycle of that customer specifically, and how we should think about that going forward over the next maybe 12 to 18 months?

Okay. Good multipart question there. Let me kick things off with eCommerce. We're thrilled with the performance of our eCommerce business, continue to see strong demand, all of the consumers metrics are improving given the strength of the marketing, and the good work that's being done by the retail eCommerce teams. More people are being drawn to the brands. So we're reaching more customers. It's a highly effective way of engaging the consumer. It's the number one way consumers engage with our brand online.

I am biased but I think we've got a beautiful website, co-branded website that improves the convenience of shopping for a newborn to about a 10-year-old child, so we're seeing good progress with it, we're expecting to see good progress in the second half. In terms of the mobile experience, we have some good work underway to continue to strengthen the mobile experience. Good efforts underway to create more of an Omni channel experience, so that the consumer can browse at home, purchase online at home, and then pick up in the store. Those things are underway. We have some tests underway and we'll probably have more to share with you later this year and into next year. So good efforts underway we just could not be happier with the progress that we're making with the eCommerce business. You had another question on--?

Wholesale, it is Brian, just to comment on that. We've got a broad portfolio of wholesale customers, some are up, some are down overall, we continue to plan that business at low-single digit growth. We do not manage the business by quarter. We have articulated before that we had one customer for fall that had cut us back. That situation has since stabilized. I don't have a concern about that going forward. But the majority of our customers are planning us up. We talked about the fact that for fall our bookings were down slightly, and you're going to be that impact come through the P&L in the third quarter based primarily on that one customer.

For Spring we're comparable to last year, and I see that really as a result of the market, it's been a challenging spring for a lot of folks, it was a challenging holiday season, we continue to support all of our wholesale customers. In terms of making good investments and brand presentation, helping them with their eCommerce sites as the business continues to move forward in eCommerce. And keep in mind as Richard articulated, we've got three components of wholesale, we've got a fall booking season, a spring booking season, and a replenishment component, and that replenishment component is about 25% of sales, so when you look forward to next year if we book spring comparable to last year we've got the replenishment component which we've launched a beautiful new little layette presentation which is off to a good start, we expect good growth in that business, then we've got the fall bookings for fall 2015, we have not even designed fall at this point, but the fall bookings and the fall season is the largest component of the three in wholesale. We plan that business in the low single-digit growth, we're confident that we can continue to grow it, and I think based on the industry if we can achieve those goals, that would be success.

You had a question on productivity of stores, Richard do you want to take that?

Yes. The productivity of the stores in Canada is very good, I'd say on balance reasonably similar to the performance of our stores here in the US, top line of around $2 million, good four-wall productivity in the mid to upper-20% range. We've been in transition in our stores in Canada with moving from the legacy private label assortment, and now the removal of the Bonnie Togs legacy nameplate, so now that we have a more consistent model we're pleased with the market share gains we're getting. The data suggests that the awareness of the Carter's and OshKosh brands continues to grow in Canada. We've had a very successful entrance to Quebec which was a new province for us in the last year, so on balance very pleased with the productivity of the new Canadian stores.

Outstanding. Thanks for the details. Best of luck, guys.

Thank you.

For our next question we go to Taposh Bari with Goldman Sachs.

Good morning guys, nice quarter.

Thank you.

Mike, question on product costs. So last we heard, they were planned up about 6% to 7% this year, I know you gave some nice detail earlier in the call. Can you tell us what your outlook is in terms of rate, whether it's inflation, deflation for spring 2015 on product costs? You mentioned something about expecting better margins. I don't know if it was a 2015 comment, or a spring 2015 comment, but are you referring to gross margins, merchandise margins, operating margins? If you could just help me?

The cost environment I would say for spring 2015 we are seeing a better trend in cost than we saw in 2014, so we saw more inflation than we expected this year. We are encouraged by what we saw for spring 2015. I would describe product cost increases for spring 2015 as modest. We're also encouraged by what we're seeing every day in the trend in cotton prices. If you looked at the paper this morning, cotton prices are in the $0.60 range, and earlier this year they were in the $0.80 range, and it will probably take us some time to see the benefit of that, but we think we'll probably see more benefit in the second half of 2015 than the first half. The first half of 2015 is locked down, so that line has been developed, it's been sold into the wholesale customers, but we're encouraged by what we saw for spring, I think we'll be more encouraged, we hope, from what we see for fall on the line.

And just the follow-up is on the, you mentioned you're expecting slightly better margins?

Product margins.

In spring 2015, right?

Correct.

Okay. And the follow-up question is, Richard, for you, on the guidance, my math gets me to an implied second half guide of $2.53 roughly at the mid point, I think your prior guidance was closer to $2.64, so there seems to be about $0.11 of a gap there. You put up a nice beat on 2Q revenues, you mentioned an SG&A timing shift. Can you help reconcile the difference there?

Sure. Well as we said, we do expect some higher SG&A from the timing benefit that we saw in the second quarter, so that shifts forward in the second half of the year. We are also taking the opportunity to spend against a couple initiatives that weren't funded initially as we put our plans together, but given the upside that we have generated in the first half, these are high return initiatives that we think are worth accelerating, one has to do with pursuing our initiatives around indirect procurement, which we think will drive some good savings for 2015. But on balance there's some additional technology projects that we think getting going on in the second half of this year. That's perhaps part of the delta that you're seeing. We still expect to have good earnings growth, good expense leverage in the second half.

Can you repeat the SG&A timing shift? You mentioned it, but I missed it.

It's about $3 million.

And that goes into 3Q or two half?

The majority of it would be in the third quarter.

Thanks guys, best of luck.

Thank you.

We go next to Robby Ohmes of Bank of America.

Hi. Hello?

We are here.

Sorry. Hi, this is Dan O'Hare on for Robby Ohmes.

Good morning, Dan.

Good morning. So I have a question about the side-by-side format. How does the criteria for opening a side-by-side store differ from a branded store, and then which format is more profitable?

I would say the criteria is the same, it has got to be good real estate, it has got to meet the key attributes of that particular site in terms of demographics, household income, number of young children in the area. So it is the same criteria. And the Carter store continues to be the more profitable of the two stores. It has got a margin rich business, but the returns on the OshKosh store are far better than we had seen in previous store models, so given the good returns on the investment in the OshKosh store in the side-by-side format generally, that's why you'll see a higher mix of side-by-side stores in our total store openings going forward.

Okay. Thanks. And just on the promotional environment in the wholesale channel, how does that compare to last year, and then, do you have plans to expand floor space with your wholesale partners?

I would say the promotional environment continues to be robust and there was heavy clearance in the competition, I think the specialty folks struggled with the spring weather, and moving through inventory, so there continues to be a highly promotional environment. I would point out that our AURs for the first half and then for the quarter are up, so we felt good about that. We're getting paid for the good work that our folks are going to be doing or have done. We were slightly more promotional at times, things like when we had some inventory to clear out after Q1, and pulsing free shipping on our websites. Overall our inventories are in good shape in our direct channel, and in wholesale they're in good shape as well, the majority of the accounts, their inventories are in good shape.

And floor space?

In terms of floor space, I would say that we're not losing any floor space. There are opportunities to gain. There are some incremental floor space, good things that have happened in terms of the OshKosh brand in a few accounts that we're testing, and in terms of Carter's our growth opportunity in Carter's when it comes to floor space is really around playwear, and how we can extend the brand up. We have the number one share in baby, we now have the number one share in toddler, and we'd like all of the accounts to carry a broad assortment of our toddler playwear, 4 to 7 is assorted in a number of accounts but not all, and as we've said before, we're testing even bigger sizes in our own direct channel, if we're able to have success with that, we would see that as an opportunity going forward.

Thanks a lot guys, and congratulations.

Thank you, Dan.

And we go next to Susan Anderson with FBR Capital Markets.

Good morning, and congratulations on a really good quarter. I was wondering if you can maybe update us on direct sourcing? Kind of where you're at with penetration, any color you could give us on the benefits that you're seeing, and your goal for the year-end, and also your expectations still to be at 50% over the longer term?

Yes, thanks for the question. We're on track to have a mix of direct sourcing of about 50% by 2017. The mix this year will be over 30%, so we're pleased with the progress. We're seeing the benefits that we had envisioned when we went down this path a few years ago. It gives us an ability to deal directly with factories, become more knowledgeable of what's going on in Asia, to navigate through some of the challenges of rising labor costs, so I'd say that initiative is fully on track and we're making good progress.

Okay. And then just to follow-up on that, what's the thought around any risk to air freight expense in the back half, or should we see that kind of coming back this year versus last year? And then just one more on capital allocation, if you could kind of update us on your thoughts there, and any thoughts on acquisitions and potentially how you would enter China?

In terms of air freight, we currently don't expect any significant air freight charges in the second half. That said, all you need is one factory to skip a beat, and there's always a risk on that air freight. We make those decisions, you always have a choice to tell the factory to keep the product, but our objective is to make sure that we continue to service our wholesale customers at a high level, and make sure we bring beautiful product into the market. But currently the supply chain performance I would say in the first half, far better than what we saw last year. We had significant air freight charges in the second half last year. We don't currently envision that we'll have that level of charges in the second half this year.

On capital allocation, we're always open to M&A ideas. We certainly look at a number of things that come our way given our position in the industry. We tend to see all of the significant opportunities that are out there. We're open to that. I'd say we have a fairly stringent set of criteria that we use in evaluating those opportunities. So if something comes along, we certainly have the wherewithal to pursue it. It's great to have the financial flexibility that we have. Beyond that I think we've articulated a good capital allocation framework that has us deploying excess free cash flow towards return of capital initiatives including our dividend, including share repurchase. I think that we've made good progress on that this year, we've been using some of our accumulated cash on the balance sheet for share repurchase, my guess is that we'll continue to do share repurchase going forward.

Thanks and good luck in the back half.

Thank you.

For our next question we go to Rick Patel with Stephens.

Hi, good morning, congratulations on a strong quarter.

Thanks, Rick.

Can you provide more color around pricing? It looks like you're making some progress from an AUR perspective, but the environment remains highly promotional. How should we think about your ability to continue doing well from a pricing perspective in this environment? How much can you adjust pricing before you really start to get pushed back? Secondly, any updates on how your wholesale customers are responding to price adjustments you've already made, given the weakness that they're seeing in their own channel?

Rick, a two-part question. In terms of pricing our key goal is to remain competitive and we've got a real strong value proposition here with the Company. That being said, we do attempt to offset the inflation impacts. We've taken some steps on price, it's not across the board, we've been very mindful of that. So where we've added product upgrades, some of the multipiece items we have, multipiece sets and things that have significant value are things that we've addressed in terms of pricing. We've avoided a good amount of I'd say single garment items, or those lightning rod items that are highly competitive, like opening price T-shirts, so we have been very mindful with the merchants about where we have applied price increases.

For spring 2014 again we'd say we had modest AUR growth which we were happy about in a really challenging environment. For fall we're planning to mid-single digit increase in price, which is going to offset the majority of the cost increases, not all, it's too early to call, we shipped fall product in June, we're off to a good start in our stores. In July we're off to a good start but it's too early to call the price increases and how they're flowing through. We'll have a better feeling on the next call after Back to School. Then for spring 2015 we have selective increases, most of those are rollovers from decisions we made on fall 2014 on things that roll forward to spring. We think we've got a good strategy. It's not a significant change. And we think we've put the increases in places where we deserve to get paid for it, based on the value of the product and the investments that we're making.

Second, you had asked about wholesale. I'd say the responses have been positive from the wholesale customers. There was no meaningful push back per se when we sold in fall or spring on the price actions we took. I think they felt they were well thought out as well, and that was not a significant concern from our wholesale partners.

Okay. Can you update us on the transition into the new DC? It's a very impressive facility. Are things going according to plan over there, and as you think about expenses in the back half, what's your level of confidence that you will continue to get leverage? And is it safe to assume that you'll get even greater leverage in 2015 as it ramps up further?

Transitions going well, the systems are working as expected. We have a very large labor force up there that we're training, and a lot of them are new. And so that's the current focus, to make sure that facility is as productive as we need it to be. I would say in the first half the facility performed as expected overall, and it's trending up to meet the demand level we're expecting around the holidays. Next big test of that facility is going to be around the Labor Day holidays, so we're making sure that we're squared away for that. And to your point we do envision even greater benefit as we roll into 2015. We'll have a full year benefit of that facility being up and running. A lot of the transition to the more automated systems happened about midyear this year, and our expectation is that, with another six months under their belt in the second half this year, the facility would run even more efficiently for the full year of 2015.

Alright. Great. Thank you very much.

You're welcome.

We go next to Anna Andreeva with Oppenheimer.

Thanks so much. Congratulations, guys, on a strong quarter.

Thanks, good morning.

Good morning. I was hoping to follow-up on the third quarter guidance. How should we think about gross margin given some of the higher AUR resonating, and it sounds like inventory is clean for you guys as well as in the channel, and also curious, maybe talk about the comp cadence during the quarter? Did you see any regional variability and what's imbedded in your guidance for comps for 3Q? I think you mentioned July is off to a good start. Are you guys seeing that at both brands?

On third quarter margins, we are actually planning on gross margins down slightly year-over-year. We do still have the good mix benefit from continuing to grow the direct-to-consumer businesses. There are still though higher product costs, which are in excess of the pricing action that we've taken. So that still is a drag. A bit more of that is centric in the OshKosh retail business, which we're showing good growth or expecting good growth in the third quarter. That gap between the product cost and pricing is a bit more severe there, so that's having a bit of a distortive effect.

We also have international margins which continue to be under some pressure in the third quarter, foreign currency is working against us in Canada. I would say that we have a little bit extra spring/summer product in Canada that we're working through as well, so all of that combined is leading us to a forecast that has gross margins down slightly in the third quarter versus last year. In terms of the comp gain, I will let Brian weigh in as well, April got off to a tremendous start and I would say on balance results were more modest in May and June. I think that's a pattern that a lot of folks saw with consumer traffic in the quarter.

Correct. And you asked about regions, I would say all regions in both brands comped up for the quarter, Anna, with the exception of the Southeast. In the Southeast, the main reason for that was the tourist stores, there was some softness in the quarter in the tourist stores which are primarily in the Southeast. So that is the only difference. Other than that, all regions comped positively in both brands.

Okay. Thanks so much, terrific.

For our next question, we go to Howard Tubin with RBC.

This is Courtney in for Howard today. Could you give a bit more detail on some of your plans for Back to School and fall, and any new marketing initiatives or promotions or new products? Thanks.

Courtney, we're really excited about Back to School both brands. We think we have really strong initiatives in Carter's we are launching a first for fall campaign, more wear now products, it is beautifully set in our store now and on our websites, and we are also featuring our new little layette presentation with an essentials shop online. Carter's will be supported with direct mail, digital, and then some strategic partnership work that we're doing. In the direct mail pieces we're excited they're now segmented based on the age of the child, so they go out to households whether you have a baby in the household or an older child in the household, we will be very net creative based on that. We are excited about that. OshKosh, great looking fall product reflecting some of the big strides we've made in style and value, we're focused on Back to School, being a Back to School destination for mom, the campaign is called to Back to B'Gosh, and it will be focused on denim and uniforms, and some of the great style that we have. That is also going to be supported by direct mail and digital, we also have a pretty exciting marketing campaign that we are going to be launching in Back to School based around denim. We've got a mailer out in OshKosh on school uniforms, which we have had good response to that, and then the fall catazine drops next week.

Was that helpful to you, Courtney?

Yes, that is great, thanks.

And for our next question, we go to Steve Marotta with CL King and Associates.

Good morning everybody. With regards to flat bookings for Carter's in the first half of 2015, Richard, could you comment on the normal percentage proportion of what is booked in any given half, and what is replenishment, and if you've seen that proportion change over time?

On balance replenishment is about a quarter of our business at wholesale, that's grown a bit over the last few years, and then seasonal bookings would be on top of that, and that is a seasonal number that we're quoting, so some portion of that does ship late this year in the December time frame, and then the balance ships in the first part of 2015.

So in general in any given half, it would be three-quarters prebooked, about one-quarter replenishment?

Yes, probably reasonably close.

Okay. And the other question I had pertained to the eCommerce in-house fulfillment. What is the general earnings contribution of that move this year and next year?

We haven't parsed that out, Steve. We've seen continued good improvements in eCommerce profitability. Some of that is volume based with just the tremendous top-line growth we've seen. All of the in sourcing initiatives, whether it's fulfillment or as Mike said bringing in the call center, all of that has been accretive to margins, and the operating margins are well above the Company average in eCommerce, but we haven't parsed it out by individual initiative externally.

Terrific. Thank you.

You're welcome.

And for our next question, we go to Evren Kopelman with Wells Fargo.

Thank you. Good morning. Three separate questions. The first one is, how did the outlet stores perform relative to the rest of the chain? Second question, is on the gross margin I think I heard you say some of the strength in the quarter a portion was attributed to timing. If I heard that right, could you quantify how much was that, and is that shifting into third quarter or third and fourth quarters? And then the last one in international, you mentioned the Japan going away is offsetting some of the growth in Canada in retail. When do we lap that? Thank you.

First I'll speak on the outlets. Our strongest business continues to be the brand stores, the stores closer in which we are investing in and building new stores there. As I said before, I would say the only softness in the quarter was in the tourist stores. The outlet stores did perform positive comps in both brands, albeit not to the level of comp that we had in our brand stores.

Gross margin timing.

On your question on gross margin, the comment in our remarks was more directed towards SG&A, there wasn't a particular timing issue in gross margin. International, we operated in Japan throughout all of last year, so we won't lap that until we get into the first part of 2015.

Great. Thank you.

You're welcome.

And 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.

Thanks very much. Thank you all for joining us on the call. I appreciate your interest in our business. We look forward to updating you again on our progress in October. Goodbye.

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