Carter's Inc (CRI) 2018 Q3 法說會逐字稿

Welcome to Carter's Third Quarter 2018 Earnings Conference Call. On the call today, we have 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. (Operator Instructions)

Carter's issued its third quarter 2018 earnings press release earlier this morning. A copy of the release and the 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 and the presentation materials posted on the company's website.

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 on the company's earnings release and the presentation materials. Also today's call is being recorded.

With that, I'd now like to turn the call over to Mr. Casey. Sir, please go ahead.

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'd like to share some thoughts on our business with you.

As reported this morning, we did not achieve our third quarter growth objectives. Lower traffic over the Labor Day holiday, lower demand from international customers and lower-than-expected replenishment trends all weighed on the growth that we had thought was possible. Thankfully, in the weeks that followed Labor Day, sales trends have improved significantly. Weather has turned cooler and demand for our fall and holiday product offerings is now trending ahead of plan.

With respect to our performance in the third quarter by segment, we had the largest shortfall to our sales plan in our Retail business. Comps were up less than 1%. We had planned comps up over 3%. We saw an unusual decline in traffic during our Labor Day holiday sale. 80% of our Retail shortfall in the quarter occurred during our holiday promotion with comps down nearly 20%. Our best analysis of the Labor Day weekend performance suggests our pricing was very competitive, but our marketing messages did not effectively communicate our strong value proposition. In the weeks that followed Labor Day, our retail comps were up 13% through the end of the quarter, and we're currently seeing double-digit comp growth in the fourth quarter with stronger traffic to our stores, higher conversion rates and better price realization driven by the strength of our product offerings.

In the third quarter, our new stores performed in line with our expectations. Our co-branded stores continue to be our best performing stores with comps up 6% in the third quarter and double-digit growth fourth quarter-to-date. Our co-branded store model is unique in the young children's apparel market. These stores provide 2 of the best-known brands in 1 convenient location for families with young children. Our co-branded stores are our most productive stores and provide the highest return on investment relative to our other store models. Together with our side-by-side stores, our dual-branded stores have grown to be over 35% of our portfolio. Beginning this year, we plan to open about 160 more co-branded stores by 2022, improving the mix of these stores to at least 50% of our store portfolio.

We also plan to close at least 115 less productive stores by 2022, largely stand-alone Carter's and OshKosh stores, many in declining outlet centers. About 1/3 of those closures are planned to occur this year. Collectively, the stores scheduled to close had less than a 2% operating margin last year. Those stores to remain open had an operating margin of over 20%. As we close these stores, we are seeing about 20% of their sales transferred to our other stores located in an adjacent market. The profitability of those transferred sales flows through at a very high margin, given the fixed cost structure of our store model.

Our objective with these openings and closures is to improve the productivity of our stores and to strengthen the consumers' experience with our brands. Our multi-brand customers are our most valuable customers. Our data shows that the number of our multi-brand customers grew over 20% this past year and their annual spend is 2 to 3x that of our single-brand customer. Consumers have rated our Carter's stores as their favorite place to shop for 0 to 24-month apparel. Over the past year, 83% of our customers shopped in our stores. In most cases, our relationship with consumers starts in our stores, and with our Age Up initiative, we plan to extend the length of those relationships. Those customers who shop both online and in our stores now spend more than twice the annual amount of our online-only customers.

Growth in our U.S. eCommerce sales in the third quarter was less robust than we had seen in the first half. First half eCommerce comps were up in the mid-teens. By comparison, comps grew by less than half that rate in the third quarter. In years past, we've been fortunate to have strong international demand for our brands. But as we've seen in recent years, the stronger dollar has had an adverse effect on our international customers. Demand from domestic consumers in the quarter grew about 13%. Demand from international consumers was down about 10%. We saw the biggest declines in demand from Brazil, Argentina and Russia, each of which saw double-digit devaluation in their currencies relative to the U.S. dollar in the third quarter. ECommerce sales in October have rebounded to double-digit growth, driven by higher domestic demand. International demand is still down to last year.

We are forecasting 4% to 5% growth in our Retail segment this year with comps up 2% to 3%. Our comp goal is 3% or better. And if current trends in our business continue, we believe that goal will be achieved. Going forward, we are expecting mid-single digit growth in our Retail segment.

Our Wholesale sales in the quarter were lower than last year, largely due to the loss of Toys "R" Us and Bon-Ton, 2 historically good customers of ours. For the year, we're forecasting our Wholesale sales down about 3%. What we lost in sales to Toys "R" Us and Bon-Ton, we are partially recapturing with other customers. As the largest supplier of young children's apparel to the largest retailers in the country, we have insight into how our brands are performing with every major retailer. Retailers who have a broader scope of baby-related product offerings, including car seats, strollers, diapers and formula, are benefiting most from the Toys "R" Us store closures. In our stores, we're seeing the best lift in sales at stores within a 5-mile radius of the closed Toys "R" Us stores. As more time passes since the Toys "R" Us store closures this summer, we're seeing an improved trend in our store sales.

With respect to replenishment trends, earlier this year, we launched our annual refresh of Little Baby Basics that's the core essentials component of our Carter's baby product offerings. To date, replenishment trends, exclusive of Toys "R" Us, are better than last year, but the growth is less than we planned. What we have not seen this year in the growth of Little Baby Basics, we are seeing in the growth of our exclusive brands sold collectively with Amazon, Target and Walmart, 3 retailers which we believe are benefiting most this year from the Toys "R" Us store closures. That's the beauty of our business. Our brands are sold in over 18,000 retail store locations and through every major online retailer of young children's apparel. No other company in young children's apparel has our extensive market presence. Wherever consumers are shopping for young children's apparel, they will likely see a strong presentation of our brands.

Store closures in our Wholesale business have been disruptive to our growth plan this year. Longer term, we see these closures positively. Going forward, we will be serving fewer, better and larger retailers, who have the ability to invest in their businesses and our brands, to provide a better experience for consumers. Going forward, we expect to see low-single digit growth in our Wholesale segment.

We expect International sales to grow about 5% this year and contribute about 13% of our total sales. In the third quarter, sales were lower than expected. Like our experience in the United States, unusually warm weather weighed on Canada's results. Cooler weather is now driving strong double-digit comps in the fourth quarter. To a lesser extent, sales in Mexico and China were also below plan in the quarter.

I was in Mexico earlier this month, the integration of that new business is going well. It has a first-class management team and it's a good multichannel model. Its wholesale business is currently larger than its retail business. We'll be testing a new co-branded model in Mexico next year. We hope to replicate the success we've seen with that store format in the United States and Canada. We also plan to launch eCommerce capabilities in Mexico next year.

We are changing our business model in China. We had a disjointed effort managing the eCommerce business separately from the brick-and-mortar business. Carter's was directly managing the eCommerce business, our wholesale partner was managing the stores, and we were unintentionally competing against each other. China is a very attractive market for kids' apparel, given 4x the number of annual births relative to the United States. We're exploring a new model, which envisions a China-based partner managing both the online and off-line businesses under a licensing arrangement. Our objective is to build a stronger foundation for growth in China and to do so with a capital-light and more profitable model. This was our approach to entering Canada and Mexico. Those are 2 very profitable businesses for us today. We're forecasting mid-single-digit growth in International sales this year. That is currently our planning assumption for growth in the years ahead.

Some of the risks we're assessing going forward are rising product costs and the exposure to new tariffs. As we shared with you on our last call, we are planning low single-digit cost increases for Spring 2019. After several years of consistently lower product costs, driven in part by the success of our direct sourcing strategy, we are forecasting low single-digit increases in product costs beginning in the fourth quarter this year. We've raised our Spring 2019 prices to help mitigate the margin impact of those cost increases. Longer term, we are assuming a more inflationary cycle with low single-digit increases in product costs and consumer prices. Just for context, every percentage point increase in our product costs adds less than $0.04 to the unit cost. So even with the related price increases, we believe we will be offering significant value to consumers.

Tariffs imposed earlier this year on imports from China are not expected to have a material impact on our 2018 or 2019 growth objectives. Our product categories were largely excluded from those tariffs. That said, this is a fluid situation, and we'll continue to monitor the reports on trade negotiations. In recent years, we've been reducing our exposure to China given lower-cost opportunities in other countries. Given the risk of additional tariffs on apparel, we plan to further reduce our exposure to China beginning next year. If additional tariffs are enacted, we will pursue additional price increases and reduce spending to help mitigate the impact of higher-than-planned cost increases.

In terms of guidance, in July we were intentionally cautious forecasting growth in the third quarter. Consumer demand during seasonal transitions is difficult to forecast and, in our business, highly dependent on weather. Our forecast in July did not contemplate the unusually hot weather in the Northeast and other parts of the country in early September, which is the largest month of sales for our company. The weather risk historically is lower in the fourth quarter.

We have 9 weeks to go this year. Given our experience in the third quarter, we have tempered our fourth quarter growth objectives and believe there may be more upside than downside in our forecasts. Currently, demand for our fall and holiday product offerings is very good. We're currently outperforming our forecast given what we believe is pent-up demand for cooler weather outfitting. In recent years, we've seen good growth in the fourth quarter. Historically, as weather turns during seasonal changes each year, we have seen a surge in demand. That's currently what we're seeing in our business.

Carter's is the #1 brand for baby apparel and sleepwear. We have 5x the market share of our nearest competitors. Both product categories are purchased in higher quantities as weather turns cooler and during the year-end holidays. We're also seeing a strong response to our holiday playwear, including the larger sizes added to our Carter's brand this year. Our Age Up initiative is off to a strong start and provides a new source of growth for us in the years ahead.

In summary, despite the challenges this past year, we are in the home stretch of what we expect will be a record year of sales and profitability and our 30th consecutive year of sales growth. We made significant investments in our business this year. We believe we have strengthened our multichannel, multi-brand business model and are uniquely positioned to outperform the market and gain share. We own 2 of the best-known and best-performing brands in young children's apparel. To the best of our knowledge, no other company in the world has our brand reach or success in young children's apparel.

I want to thank all of our employees who are focused on delivering a strong finish to the year. I'm grateful for their commitment to strengthen our brands and to serve the needs of families with young children.

Over the next few months, we will refresh our growth plans based on our experiences this year. Based on our current estimates, we are planning good growth in sales and earnings next year.

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

Thank you, Mike. Good morning, everyone. I'll begin on Page 2 of today's presentation materials with our GAAP basis income statement for the third quarter. Most of my comments today will speak to our results on an adjusted basis.

This year's Q3 GAAP results include a $3.5 million charge related to changes in our China business model. Last year's Q3 GAAP results included net charges of $0.5 million, principally related to store restructuring costs and acquisitions. Note that our adjusted results exclude these charges in both periods. Our year-to-date GAAP P&L is included on Page 3. Today's presentation and earnings release include reconciliations of our GAAP basis results to the adjusted basis of presentation. I encourage you to review this information as you evaluate our results.

Moving to Page 4 with some highlights of the third quarter. Consolidated net sales declined 2.5% compared to last year. The principal driver of this decrease was lower sales in our Wholesale segment, offset by slight growth in our Retail and International segments. Discontinued sales to Toys "R" Us, Bon-Ton and Sears weighed on our results this year. Sales to these 3 customers in last year's third quarter were approximately $34 million. Fortunately, we did not have receivable or inventory exposure in connection with Sears' recent bankruptcy filing.

Adjusted operating income declined 18%, reflecting lower sales and investment spending. Adjusted earnings per share declined 5% compared to last year to $1.61 with the benefits of a lower effective tax rate and lower share count, partially offsetting lower operating income.

On our July call, we had guided to roughly comparable sales and earnings for the third quarter. Relative to this forecast, retail sales around the key Labor Day selling period and, to a lesser extent, replenishment demand in Wholesale, were lower than we had planned. The decline in profitability versus the forecast tracks to the lower sales, particularly in Retail, and we had higher fulfillment expenses and inventory related costs.

Moving to our adjusted P&L for the third quarter on page 5, beginning with adjusted gross margin. Adjusted gross margin was 42.2%, down 40 basis points compared to last year. This reflects customer mix changes within Wholesale and higher freight and shipping costs in our eCommerce business, offset somewhat by sourcing efficiencies. Royalty income was roughly comparable year-over-year.

Our adjusted SG&A rate was 31.7% compared to 29.9% in the third quarter of last year. As we've articulated on previous calls, we've had a strong investment agenda, particularly in support of our retail businesses over the past few years. We've invested in new stores, marketing, distribution capacity, eCommerce delivery speed and omni-channel and retail technology capabilities as well as investments in company infrastructure to support our growing and diverse enterprise. We've not yet seen the full benefit of all of these investments, but believe they will help drive our business in the quarters and years ahead to enable greater productivity and capabilities across the company. We have a good process to evaluate the efficiency of our spending, and will continue to critically evaluate which areas merit continued investment.

In the third quarter, we've estimated that approximately $16 million of SG&A relates to the investments in the areas previously mentioned and as much as $50 million on a year-to-date basis.

Third quarter net interest and other expense was $10 million compared to $7 million last year. Interest expense in the third quarter was about $2 million higher than last year due to higher borrowings and higher market interest rates versus a year ago. Our third quarter effective tax rate declined to 23.5% from 33.2% a year ago, reflecting the benefit of U.S. tax reform legislation passed at the end of last year.

Our average share count declined 3% compared to last year, driven by our share repurchase activity. So again, on the bottom line, third quarter adjusted EPS was $1.61, down about 5% from $1.70 last year.

Page 6 summarizes our year-to-date adjusted results. Through the first 3 quarters of 2018, net sales were comparable and adjusted EPS grew 1% over last year.

Turning to Page 7 with a summary of our balance sheet and cash flow. We ended the quarter with strong liquidity with cash on hand and available borrowing capacity on our revolver totaling approximately $470 million. With the benefit of the new U.S. tax law, we were able to repatriate $65 million in overseas cash during the quarter.

Net inventories at the end of the third quarter were up 14% versus last year. As expected, inventories were higher for several reasons including new growth initiatives across the business, the timing of inventory receipts and higher on-hand baby replenishment inventory. At present, we believe the overall quality of our inventory is good with net inventories currently up high single digits over a year ago, so already a nice decrease from our quarter-end position. We anticipate good sales growth in the fourth quarter and early next year and project year-end net inventory growth at the end of this year to moderate to approximately plus 8%. We've determined to carry higher inventory in a few specific areas of the business, notably certain programs within retail and in support of our exclusive brand businesses, which have been performing strongly.

Operating cash flow in the first 3 quarters of 2018 was $21 million compared to $118 million last year, reflecting lower earnings and the higher inventory position at quarter-end.

Historically, we've generated the majority of our annual operating and free cash flow in the fourth quarter of the year, and we expect that will be the case this year as well. We're currently projecting that full year operating cash flow will be in the range of $300 million to $325 million. Our outlook for capital expenditures has moderated a bit and we're now projecting to spend approximately $75 million this year.

We continue to execute against our return of capital agenda. Through the first 3 quarters, we have returned a total of $209 million to shareholders comprised of $145 million in share repurchases and $63 million in dividends.

Now turning to Page 9 with an overview of our business segment performance in the third quarter. Our consolidated adjusted operating margin was 11.6% compared to 13.8% in last year's third quarter. The drivers of this decrease were lower profitability in our U.S. Retail and Wholesale businesses, which I'll cover in some more detail. Adjusted business segment results for the first 3 quarters of 2018 have been provided for your reference on Page 10.

Moving to third quarter results for U.S. Retail on Page 11. Total U.S. Retail segment sales in the third quarter increased 1% versus last year. Our total retail comp was up 0.5%. As Mike mentioned, results in U.S. Retail were lower than we had forecasted, which we've attributed to several factors.

First, our performance around the Labor Day holiday period was below our forecasts. A year ago, we enjoyed a marked cold snap around Labor Day, which, we believe, helped drive strong early September performance. Temperatures around the country were obviously much warmer this year.

Our promotional messaging did not resonate with consumers during the Labor Day period, so we've adjusted our marketing to more effectively connect with our customers. ECommerce sales were lower than we had anticipated.

In addition to the Labor Day and promotional factors, which I've mentioned, we believe the stronger U.S. dollar negatively affected traffic and sales from international consumers shopping on our U.S. website. We've seen this phenomenon in the past when the U.S. dollar strengthens against foreign currencies.

After the Labor Day holiday period and with the arrival of cooler weather, U.S. Retail sales trends improved meaningfully with comps up in the double digits over the last 3 weeks of September.

Q4 is off to a good start as October month-to-date comps are up in the double digits. As Mike said, we continue to make progress with our store portfolio optimization initiative. Our co-branded format continues to resonate strongly with consumers. We believe an important element of improving the productivity of our retail store portfolio over time will be the increasing balance of stores in the co-branded format.

U.S. Retail segment margin was 10.3% compared to 12.8% in the third quarter of 2017. This performance reflects higher eCommerce shipping and fulfillment expenses and higher spending on marketing and technology investments.

We're expecting retail comps in the fourth quarter will be up about 4%, driven by a number of initiatives including the contribution from our Age Up size expansion, additional marketing spend and a greater contribution from Skip Hop.

On Pages 12 through 14, we've included some of our holiday marketing. On Pages 12 and 13, we highlight some of our special holiday outfitting items in this year's assortment.

And on Page 14, consumers have told us for years that they'd love to be able to join their children in wearing our iconic Christmas pajamas. This year, we're letting mom and dad in on the fun by offering select adult pajama sizes online, which means the whole family can be in Carter's jammies in this year's Christmas card photos.

On Page 15, we have our latest Carter's Instagram posts. In the third quarter, Carter's once again captured the greatest social media engagement among our peers on Instagram by securing all of the top 25 engagement scores.

Turning to Page 16 with results for our Wholesale business in the third quarter. Sales in U.S. Wholesale were down about 8% versus a year ago. We had planned third quarter wholesale sales down year-over-year. This decline was largely driven by discontinued shipments to Toys "R" Us and Bon-Ton, calendar differences between us and several of our wholesale customers, many of which have a 53rd week in their calendars this year, also contributed to some shipments falling into the fourth quarter this year. Relative to our previous forecast, replenishment demand in Q3 was somewhat lower than we had planned. We saw good growth in replenishment demand across wholesale, just not quite at the level we had planned. Replenishment demand has been particularly strong for our exclusive brands.

We're expecting strong net sales growth in U.S. Wholesale in the fourth quarter, up in the mid-single digits over 2017. Segment operating profit was $68 million compared to $79 million last year. Segment margin was 20% versus 21.3% a year ago. This margin performance reflects changes in customer mix, higher spending on marketing and higher provisions for bad debts and inventory.

For the full year in 2018, despite the negative impact of the discontinued sales and some higher provisions for uncollectible accounts, we're forecasting the operating margin for U.S. Wholesale to be approximately 20%. We believe we will recapture about half of the $80 million of sales to Toys "R" Us and Bon-Ton we had originally planned for Q2 through Q4. We're particularly pleased with demand for Skip Hop in the wholesale channel. Skip Hop has largely recaptured all of its lost Toys "R" Us sales with increased demand from our other wholesale customers. Similar to our U.S. Retail business, selling in the Wholesale channel so far in the fourth quarter has been very strong

Page 17 features a photo of a new baby shop at a Kohl's store in the Atlanta area. We've partnered with Kohl's to support the recent rollout of 150 new Carter's baby shops. Locations were selected based on proximity to closed Babies"R"Us locations. We believe delivering a high-quality brand presentation wherever mom shops is a point of differentiation for us. In these baby shops, the updated fixtures optimize floor space and capacity while providing a modern fresh look with our great Carter's photography. Early returns on these investments are encouraging.

Page 18 features our Child of Mine brand, which is available exclusively at Walmart. Walmart recently strengthened the in-store presentation of the Child of Mine brand, which can be found in virtually all of Walmart's 4,000 store locations in the United States. We believe Walmart is seeing strong returns on these investments to better showcase this exclusive brand in their stores.

On Page 19, we have some imagery from target.com, featuring the Just One You brand, which we created especially for Target. Like many of our wholesale customers, eCommerce is an area of investment and emphasis for Target. We think this online presentation does a great job conveying the style and value of the Just One You assortment.

On Page 20, Simple Joys continues to be an important growth initiative for us. This brand was introduced on Amazon last year and has been growing rapidly. We recently introduced Simple Joys toddler product, which complements our initial launch which was focused on baby and sleepwear. Simple Joys growth continues to ramp-up, and we've seen a notable increase in demand recently since Amazon made this brand available to all of its customers. Up to this point, Simple Joys was an exclusive offering only for Amazon Prime customers.

On Page 21, we've included photos of 2 notable wholesale points of distribution for our Skip Hop brand. First, Amazon recently opened its first 4-star concept in New York City. As the name implies, the store features items that customers have rated on average 4-stars and above. Included in the launch of this store is a focused assortment of our Skip Hop products. Second, we've expanded Skip Hop's presence at Macy's by introducing a new fixture in 45 locations and adding a second fixture in nearly 70 existing locations. This expanded presence builds on the brand's successful introduction in Macy's in 2017.

Moving to Page 22 and International segment results for the third quarter. International segment net sales grew 1% in the third quarter, reflecting the contribution from our 2017 Mexico acquisition and increased demand in various markets outside of North America. This growth was mostly offset by lower demand in China and unfavorable movements in foreign currency exchange rates. On a constant currency basis, third quarter International segment net sales grew 4%. Through the first 3 quarters of 2018, our International segment has achieved growth of 6% over last year.

Canada, the largest component of our International business, grew net sales 3% on a local currency basis with retail comps of plus 3% as well. Similar to our experience in the U.S., we believe warm weather weighed on Canada's results in the third quarter. Canada's retail business is off to a strong start in Q4 with comps currently up well into the double digits as cooler weather is driving higher demand for fall product offerings.

Q3 sales in the Mexico market, which includes the business of our former licensee which was acquired last year, were $17 million, up nearly 30%. As Mike said, our team in Mexico is making good progress in building out its multichannel business in this attractive market.

International segment adjusted operating income was $16 million compared to $17 million in the third quarter of last year. Segment operating margin was 12.7% compared to 13.5% last year. This margin performance reflects lower profitability in China and Canada, partially offset by improved contributions from other international markets.

Looking ahead, we're planning good growth in our International segment in 2019. In addition to growth in Canada and Mexico, we expect to benefit from the addition of several new wholesale partners in markets such as India, the United Kingdom, Russia, Greece and Ukraine, to name a few.

Pages 23 and 24 showcase some of the newest stores operated by our international partners. These 25-or-so partners operate stores in over 80 markets worldwide. Page 23 features a Carter's store at the Mall of the Emirates in Dubai. This new upsized location strengthens what has historically been one of the most productive Carter's stores in the world. Page 24 is a photo of a new co-branded store in Perth, Australia. This is our partner's first store on the West Coast of Australia and this store is off to a very strong start.

Moving to our outlook for the fourth quarter on Page 26. We're expecting a good fourth quarter with growth in all of our business segments. We've moderated our expectations somewhat relative to our previous forecast, principally to reflect a more cautious outlook on retail comps and wholesale replenishment demand. We're assuming Q4 retail comps will be up about 4%. As we've said, the fourth quarter is off to a strong start and if current trends continue, we may have some upside to our forecast. For the fourth quarter, we expect consolidated net sales to increase approximately 5% and adjusted earnings per share to increase approximately 10%. We expect year-over-year growth in SG&A will be lower in the fourth quarter than year-to-date, and we're planning SG&A leverage for the fourth quarter as well.

If we're successful with our fourth quarter plans, we would end the year with sales growth of approximately 1.5% and adjusted EPS growth of about 5%. Risks that we're watching closely include the level of promotional activity in the marketplace, international consumer traffic and demand in our U.S. Retail businesses and the status of trade negotiations between the United States and China.

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

(Operator Instructions) Our first question comes from Kate McShane from Citi.

I was wondering if we could walk through the Toys "R" Us recapture again. Originally, you had told us you had achieved $20 million out of the $40 million when you last spoke to us in July. Can you update us on what you think you captured during the third quarter? And then just still on the same subject, could you maybe walk us through what the environment has been like post Toys "R" Us? And when you start to see sales improve? Was there a pull-forward of demand from the liquidation that's causing some of the overhang? And does your 2019 outlook include any additional recapture you expect to see?

So your recollection is correct. We were about $20 million of the $80 million we just put in context. We lost probably about $80 million of balance of year shipments that we had planned to make after we heard that Toys "R" Us and Bon-Ton planned to close all of their stores. So through July -- and we assumed we'd recapture about half of that, about $40 million of the $80 million. And through July, we probably had felt as though we had at least a line of sight on $20 million of additional demand, largely from wholesale. The mix was going to be largely driven by additional wholesale demand. So we had a line of sight to about $20 million of that.

I think through today, we probably picked up an additional $10 million, so we're -- I'm rounding here, about $30 million. Then in the balance of the year, we're -- we've got 2 very significant months ahead of us we expect to have the balance of the $40 million. So the analysis I've seen would suggest that we'll recover more than $40 million. We had hoped that it would be a bigger number. But at least what we have shared in our forecast with you was that we felt as though we had a high confidence level that we would recapture $40 million of the $80 million that we had planned to ship to those 2 customers.

And then in terms of the business, I would say we were very disappointed in the Labor Day performance. Labor Day for us is an important holiday. It's probably second only to the Black Friday holiday, and so we were very disappointed in the performance. To share with you, the comps during our Labor Day promotion were down about 20%, if you excluded the performance over that Labor Day holiday promotion, I think the comps were up -- probably going to be up some portion about 4% or 5% for the quarter, it was that impactful. In the weeks that followed Labor Day, our comps were up around 13%. So we saw the consumer starting to embrace the fall and holiday collections much more so than they did over the Labor Day holiday. And then October performance has been outstanding. And this is what we've seen in our business over the years. When the weather turns, when it turns from warm to cold and then in the Spring from cold to warm, we see a surge in demand for our product offerings, and that's what we've seen in the recent weeks. So business has been very, very good.

That said, we've got 9 very large weeks ahead of us. We don't want to assume what we've seen in recent weeks is going to continue through the balance of the year. So we've been -- we're -- we realize that we came up short with our third quarter. We're determined not to do that in the fourth quarter. So we've tempered the forecast to a level where we have a high confidence level in these forecasts.

Okay. Great. And if I could just ask 1 more follow-up question about your Labor Day comment? In the prepared remarks, I think you had mentioned that you pivoted the marketing message a little bit. I just wondered why do you think -- what do you think it was about the messaging that wasn't really conveying your value proposition, especially because the brand is already known as having good value? Were the competitors just more competitive than usual around this time period?

Well, that weekend is always competitive. I think in retrospect, I think our marketing message was too heavily weighted to the promotion and not to the strength of the product offering. So those were some of the changes that we made after what we saw over Labor Day and the consumer responded to it.

Our next question comes from Ike Boruchow with Wells Fargo.

Two questions. I guess, maybe, Richard, the first question is just looking at the Q4 outlook you have now relative to a couple of months ago, kind of, understanding the sales are a little bit below. But given you're expecting some SG&A leverage, it seems like the gross margin pressure, maybe, is more meaningful than you thought. Could you maybe walk us through your thoughts on gross margin for Q4? And then, kind of, tying that to the inventory, ending Q3, are you a little bit heavy and you're implying some more promotion and markdown that's going to be needed relative to your last outlook? Just kind of curious on holiday margin.

Okay. Sure. Well, I think there are a few points of pressure year-over-year as it relates to gross margin, but largely the trends that we've seen to-date in the business more than anything. So in Wholesale, you have the change in customer mix, the loss of the TRU and Bon-Ton volume, which was very high margin for us. The growth is coming from some of the lower margin businesses in Wholesale, they're good growing businesses, they're just not quite at the same margin of what we lost with Toys "R" Us and Bon-Ton. Within retail, there probably is some minor effect of some inventory clearance, although we've made very good progress with that. And by the time we got to the end of the quarter, we had moved through quite a number of units. That's probably less of an issue.

One issue that we have faced in the gross margin structure within eCommerce has just been some higher shipping costs and fulfillment costs. That business has been a bit more variable. So we haven't had quite the same distribution efficiencies that we've enjoyed in our Braselton DC. I think the slowdown in demand from international consumers that tend to buy more units per transaction has affected some of those efficiencies as well. And we are investing in expedited shipping as well to make sure that the orders get to consumers on a more rapid pace than they did a year ago.

I'd say, the upsides to the margin year-over-year, we're expecting better margins in Canada, we're seeing a nice lift in margins in Skip Hop and we're driving some other efficiencies in our supply chain, all of which are coming through the gross margin line.

And Richard, can you say with more detail on what your expectations are for Q4 on the gross margin line?

Well, I would say we'll continue to enjoy that nice serial lift that we got going from Q3 to Q4, where we have a higher proportion of retail sales relative to the third quarter. I do expect some modest pressure year-over-year in the margin rate.

Got it. And then just last question. You've given us some breadcrumbs to next year on the top line on U.S. Wholesale, low single digits and good growth International and your comps are obviously better quarter-to-date. I guess, I'm just curious, the margins -- there's different things that are, kind of, taking place, direct sourcing has gone a long way, product costs are now inflationary. I guess just thinking about the algorithm of the business into next year, you guys -- how do you balance growth? Or I guess, said differently, are you able to view the business as having the same type of growth that it's had in prior years?

We'll know more -- we have a lot of work to do between now and the balance of the year. We're developing our revised long-term plans through 2023, and we'll redo that -- those assumptions with our board in the balance of the year and early next year. We'll have more to share with you in February. But our plan is continue to have good growth and -- both in sales and profitability. We're disappointed where we come out this year in terms of our operating margin. We felt as though we would have done better. But to Richard's point, we lost a very high margin customer in Toys "R" Us this past year and we took a step back on our Retail business in the third quarter. Those are probably 2 big misses relative to the growth that we envisioned possible this year. But our plan going forward is that we'll have good top line growth and we'll have good margin expansion going forward. So we'll have more to share with you. It's premature to be more specific today on the growth plan for '19 through 2023.

Our next question comes from Susan Anderson with B. Riley FBR.

I guess I wanted to ask about the miss in third quarter. I guess, how much do you think was weather-related versus maybe some other factors such as pull-forward of demand from Toys "R" Us? And then just a follow-up on Ike's question on the fourth quarter guide. I guess, I'm trying to figure out what's changed from your original expectation for fourth quarter, because it seems like maybe top line is a little bit better. So on the margin front, that's come down a bit. But it seems like the loss of -- like the Bon-Ton business or Toys "R" Us was known. So maybe if you could just, kind of, talk about what's changed within that margin outlook. That would be great.

As it relates to fourth quarter, our implied guidance for fourth quarter top line would've been growth closer to 6% or 7%. We've moderated that to be the roughly 5% that we talked about today. And I think there is a healthy dose of just being cautious with that. We've seen the shortfall from Labor Day, which is a big volume period. As Mike said, these coming weeks are very high for us. Business is very, very strong at the moment, but we're being a bit more cautious in our outlook.

On the margin front, I don't know that there is a dramatic change in our outlook there. I think most of the change in profit outlook tracks to below our top line, where we're taking most of that out of the Retail business, which is good margin business for us. I think, we are cautious on the factors I mentioned related to shipping margins and shipping costs. We are seeing some higher labor costs there. We're seeing the investment in expedited shipping, which is weighing a bit on margins.

Your question how much weather played a role in the third quarter. Labor Day, it did. We happened to be in New York the days after Labor Day. It was unusually hot. And keep in mind, Labor Day weekend, we're selling blanket sleepers, we're more fall-forward. So it's understandable, the weather would have had an impact. But we look for things other than weather. Again in retrospect, we felt as though the marketing message missed the mark.

Other things that worked against us, the eCommerce demand was not what we had expected in the third quarter. It was less than half the rate of growth that we had seen in the first half and it was lower international demand. We had good growth in domestic demand, good double-digit growth in domestic demand, but international demand was lower.

And I'd say, we've referenced the replenishment trends in our core Carter's Little Baby Basics. The replenishment trends are up. Year-over-year, they are up, excluding the impact of Toys "R" Us. With the other customers, we've seen good replenishment trends, just not as good as we had hoped for. And the further we -- away we get from the timing of those Toys "R" Us store closures, the better the trend in the sales have been, both in replenishment and in our own store sales. So there's no question, there was a pull-forward of demand with those Toys "R" Us store closures. People were loading up basketfuls of product, and so that product is -- children are outgrowing that product, we're starting to see better trends in our sales.

Great. That's helpful. And then just one follow-up. Maybe if you could talk about. If you see sales pressure both across baby and then young kids, I think you talked about the size-up initiative doing pretty well. But maybe there's a little bit heavy inventory in the baby category. And with that, I guess, do you feel like you've lost any market share in baby recently?

Susan, just to follow-up on your question. Couple of things. We continue to have good baby business. I think, this shift we're studying very closely where it seems to be overweighting to our exclusive brands. As Mike said, when folks are shopping more at the Targets and Walmarts, Amazons of the world, so our business is very good there. We have good baby business in other accounts, just didn't elevate enough to offset the TRU situation. So we continue to watch that. Births are down, so that does put pressure on the baby business. But our goal is to overcome that. So we continue to focus on that business and make sure that we double down our efforts on our direct channel and with our wholesale customers to continue to drive growth in the core of our company. I think that we showed the Kohl's presentation we've had. We've invested in digital marketing with many customers. And we continue to press many efforts to continue to grow our baby business, and we're very, very serious about that. And we think that we'll be successful with that.

In terms of Age Up, we feel good about that initiative. In July, we launched that Carter's KID line as a way to extend our relationship with the customer. It was kind of the second phase of the "With You From The Start" campaign. And both the product launch and the marketing was well received by our customers. In Q3, sales in that 5- to 10 -year-old segment of our Retail business grew by about $10 million and most of it came from the bigger sizes. So that strategy does represent a significant opportunity for our company. We added that 1 size, size 8 a few years ago, if you'll recall, and we're now garnering about $80 million in sales from that initiative. So in adding these sizes, age 10 to 14, we can fully address that 5- to 10-year-old market, and each share point of that is an opportunity of over $100 million for the company.

So we're going to continue to focus on baby and grow that business, and we feel good about our share, but we're going to continue to make sure we strengthen that. And that we've got this incremental opportunity with Age Up, which we feel good about as well.

Our next question comes from Heather Balsky with Bank of America.

So a key competitor has expressed a willingness to promote pretty aggressively to drive share. How is the promotional environment quarter-to-date? And how do you think about your ability to pass-through price next year if the environment does get more promotional?

Sure. I'd say that it continues to be promotional. I can't recall a time when it wasn't promotional. But I would say every good retailer is focused on inventory management, buying fewer units, trying to improve price realization, improve sell-throughs, sell less at the end of the season on the clearance rack. By and large, we're seeing a number of our customers having good, better margins year-over-year with our brands. So it'll continue to be noisy in terms of the messaging.

But I think every good retailer we know is trying to get -- improve the profitability of their sales. So going forward, we're looking at what I would characterize as modest price increases, and on like-for-like product, modest price increases. And as I shared with you, just for context, every percentage point of cost increase for us represents less than $0.04 in the unit cost. So it's substantially -- everything we do, our average price points are less than $10. So it's -- with the normal inflationary cost increases, we think that, that will not be an issue passing those along to the consumer.

Even as we looked at the exposure to the tariffs, if for some reason that all of the imports from China are subject to that 25% tariff, I would say that, that challenge would be comparable to what we saw during the cotton crisis back in 2011. And during the cotton crisis, we improved our pricing by about $0.50 a unit, and we had very good top line growth that year and did a good job recovering from that spike in cotton prices. So I think we have a handle on what's possible with the price increases.

But our focus has continued to be the strength in the product offering. We -- our brands are known for quality and great value. We will be competitive. But cotton prices are up, oil prices are up, transportation prices are up and so all of that we've taken into consideration in terms of what makes sense for us to continue to try to improve our margins. So that's our game plan for Spring '19.

Okay. And with Toys "R" Us, I guess, no longer -- I guess, in the back window and the growth coming from some of your lower-margin wholesale partners, how do you think about your gross margin opportunities going forward? Are there offsets to that mix shift?

Just to be clear, the reason why Toys "R" Us was a very high-margin customer for us, by and large, that was a baby business. And baby is one of the richest-margin product categories we have. So the other customers have a larger selection of the playwear, broader range of size ranges. So as you go up the -- the bigger the child, the more the fabric, the bigger the garment, there's -- it doesn't have the rich margin structures of the baby product offering. We have good margins with the other customers.

And so there's a number of margin-driving initiatives around inventory management. We're scaling up our new businesses with Skip Hop, Amazon and Mexico. We'll have a more profitable model in China going forward. Our sourcing team is doing a great job exploring new markets to source our products going forward. And pricing's a lever, it's not the biggest lever, but as we see some of these inflationary pressures, we plan to take the prices up modestly.

Our next question comes from Laurent Vasilescu of Macquarie Group.

I wanted to follow-up on China. With regards to that $3.5 million charge, can you dive into -- a little bit into the effects of the P&L with regards to revenues, gross margin, SG&A? Can we anticipate any other charges over the next few quarters? And then lastly, I forget if you'd called it out, but can you maybe parse out what -- how much sourcing comes out of China? And what that percentage rate can go down to if tariffs come into play?

Sure. Let me comment on China and then Richard will address the -- your other question with respect to China. So our -- we source less than 30% of our apparel units today from China. And China has been a great place to source the product. The execution, when we look at the things that drive our decision in terms of where we source from, it's about safety, quality, reliability. You can go to some parts of the world for a lower cost but if it never shows up, doesn't do you much good. And the last component is cost. So against those 4 things that we look for, China has been an exceptionally good place to do business.

That said, we have this exposure to tariffs. Thankfully, we've been working with our suppliers over the past year, many of which not only are based in China but they're based in Cambodia and Vietnam, Bangladesh, Indonesia. So they're helping us explore the possibility of shifting production from China, if necessary, to other parts of the world, where they produce products. So we have the flexibility to move. That's the beauty of doing business in Asia over the past 20 years. We've developed these deep relationships with great suppliers that can handle the unit volume for our company, and we've been working with them this past year to explore other places, if need be, to source our product.

And on the China charge, it was roughly $3.5 million. About $2.5 million was recorded in gross margin. That relates to additional inventory provisions that we took. The inventory for this market is unique to China. It's labeled for that market specifically, so we don't see a lot of opportunities to take it elsewhere in the world.

And then about $1 million or so related to employee severance as we're thinking about this new business model, we don't think that we're going to have the same staffing requirements that we've had with our own employees in China. So a couple million related to inventory provisions and $1 million related to severance. I do think it's possible that over the next couple of quarters, we could have some additional costs. I wouldn't envision that those would be material though to the company.

Okay, very helpful. And then in terms of the inventory growth of 14%. I think it's called out in one of the slides that there was a timing shift of receipt. Could you quantify that number? And then -- and what's the anticipated inventory growth rate for the end of the fourth quarter?

At the end of the year, I think we said that we hope that inventories will be up 7% or 8% by year-end. We're making good progress towards that. The inventory was, sort of, front-end loaded to be at that 14% at the end of Q3. I would say, there are a few specific programs in Retail, where they've chosen to bring in some programs early.

And then as I said, our exclusive brand businesses at Target, at Walmart, at Amazon all performing really well. So we're taking on some additional inventory there. If the year-end number is up 7% or 8%, the factors that I mentioned are probably a few percentage points of that growth.

Okay. Very helpful. And then maybe if I could squeeze one last question. In terms of the double-digit comps quarter-to-date and then comparing that to the guidance of 4% for the fourth quarter, can you maybe possibly remind us what the monthly cadence was, high level, for last year's fourth quarter?

Last year, fourth quarter, October we had a 1.6%, November was about 5.5% and December was about 5.5% as well. We finished up at 4.5% for the quarter.

Our next question comes from Jim Chartier with Monness, Crespi and Hardt.

I just wanted to understand the potential impact of the lower international sales. So a couple of years ago, you had a similar dynamic. So what percentage of your direct-to-consumer sales today come from overseas? And how does that compare to 2015, 2016, the last time we saw this impact?

So you're talking about International sales. So about 2/3...

So in international through your direct-to-consumer business?

Okay. Geez, when we launched it years ago, eCommerce, you're talking about eCommerce? International...

So 2015, 2016, we saw similar -- a much more dramatic change in exchange rates, and you guys broke it out for us on the calls. And I was just curious what your exposure in your direct-to-consumer business is to international spending?

At least on eCommerce business, it's around -- it's a little -- around 25%. That's the exposure. It was much higher years ago, but it has -- domestic demand has grown faster than the international demand. So it's around 25%.

And in the quarter, Jim -- it's been about 25% year-to-date. In the quarter, where international was down online about 10%, it represented about 21% of our business in Q3.

Okay. And I believe, again, back in '15, '16, you saw an impact in some of your higher volume outlet stores or tourist destinations. Are those stores still open? And are you seeing any impact in those stores as well?

Yes, a little bit. Yes, we are. Yes.

Okay. And then I'm not sure if I missed this...

With the analysis I saw, I think, the Florida stores are because that's where you see the large international customers. I think year-to-date, I think, the performance was generally in line with the change, it wasn't meaningfully different.

Okay. And then on China...

That's what we make...

Okay. Sorry. And then on China, I'm not sure if you said this, but what is China tracking to in terms of a loss for 2018?

About $7 million.

And when do you expect to, kind of, finalize the new agreement and business model for China?

We hope to finalize it in the balance of the year. We hope early next year, we've got a new model in place.

Our next question comes from Jay Sole with UBS.

Mike, I wanted to follow-up on the -- some of the outlet discussion there. Can you maybe help us understand why the performance of some of the outlet stores you called out as weaker has been so much different from your other stores? What is it that's unique about your business that's created that trend? Because broadly, it doesn't seem like the performance between outlets -- just overall from retail has been that different from malls and other retail centers?

Well, in terms of our experience has been, the outlets have underperformed the chain. And I think the last analysis I saw is, I think, in some cases we might be in some portion of 160 or so outlets, depending on the brand. And just the rule of thumb years ago, there's probably 120, 125 really good outlet centers, Orlando, Sawgrass Mills, Dolphin Mall, those are exceptionally good outlet stores for us. But relative to that, really good centers, we're in considerably more of them. And these have been historically good profitable stores for us.

But with the success that we've had with our own co-branded stores, opening those stores closer to the consumer and the success of our eCommerce business, there's fewer reasons to drive 40, 45 minutes to a remotely located outlet center. And we're closing these outlet centers as they come up for lease renewal, because we have to make a decision. Do we reinvest it? Do we freshen it up? Do we put a whole new look to it? And we -- increasingly we're concluding, we don't need to. And years past when we would decide to exit the property owner would make it very attractive for us to stay by significantly lowering the rents. But we're looking at where the arrow is pointing. And for these declining outlet centers, I think, it doesn't make sense to renew those leases. We're better of putting our energy into co-branded stores closer to the consumer, it's a much better experience. And that's what the results tell us. The consumer loves the co-branded stores, she loves the convenience of shopping these 2 brands in 1 convenient location. And so as these -- the outlet center -- a number of these outlet stores come up for renewal, we will be closing them.

Got it. It's super interesting. And maybe, Richard, if I can follow-up on the Retail segment adjusted operating margin in this quarter, yes, I think, you called out eCommerce fulfillment expenses, spending on marketing and technology, is it possible to parse out, like, what the bigger impact was to the margin of those 3 drivers? And sort of, what brought that on in this quarter? Because I think the margins the last few quarters have been pretty much similar on a year-over-year basis.

I don't know that I'll parse them out in precise detail. I think, those are the factors that affected the Retail margin in the quarter, shipping costs, we are spending more on marketing, that includes the new brand marketing campaign, a portion of that gets allocated to the Retail segment and the fulfillment expenses that I mentioned were higher. I do think some of the variability in eCommerce is the source of some of the inefficiency that drove those costs higher. And we are testing this additional spending on expedited shipments for eCommerce orders. So all of which are weighing on the margins at this point.

That concludes our time for the call. I would now like to turn the call back over to Mr. Casey for closing remarks.

Okay. Thank you. Thank you all for joining us on the call this morning. Appreciate your thoughtful questions and your interest in our business. We look forward to updating you again on our progress in February. Goodbye.

Thank you, ladies and gentlemen. This concludes today's teleconference. You may now disconnect.