Express Inc (EXPR) 2012 Q1 法說會逐字稿

Greetings and welcome to the Express, Inc. first-quarter fiscal 2012 earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Ms. Allison Malkin of ICR. Thank you, Ms. Malkin. You may begin.

Thank you. Good morning, everyone. Before we get started, I would like to remind you of the Company's Safe Harbor language, which I'm sure you're all familiar with.

The statements contained in this conference call which are not historical facts may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results may differ materially from those suggested in such statements due to a number of risk and uncertainties, all of which are described in the Company's filings with the SEC, which includes today's press release.

In addition, during this call we will make reference to adjusted net income and adjusted earnings per diluted share, which are non-GAAP measures. Reconciliations of these non-GAAP measures to reported net income and earnings per diluted air have been provided in our press release.

Now I would like to turn the call over to Michael Weiss, Chairman, President and CEO of Express.

Thank you, Allison, and good morning, everyone. I'm joined here today by Matt Moellering, our EVP and Chief Operating Officer, and Paul Dascoli, our SVP and Chief Financial Officer.

I'll begin our call today with an overview of our first-quarter performance and highlight our progress against the priorities we set for the business on our fourth quarter call. Then, Paul will review our financial results and outlook in more detail. After my closing remarks, we will conduct a question answer session.

We began the year solidly, reporting record sales and earnings in Q1, and made significant progress against our four growth pillars. While we feel good about the quarter, we believe we missed some sales opportunities in our women's knit tops category. As many of you are aware, we continue to shift our strategically shift our knit top assortment away from low retail and low margin commodity basics in favor of fashion offerings that differentiate and define Express as a fashion authority.

In keeping with this strategy, we reduced our styles of opening price point knit tops, and in hindsight, we did not follow some of our own guiding principles when planning this department this spring. We did not take a balanced approach to this category.

Sales were planned down double digits as we transitioned from commodity items. This was much deeper than we should have planned for one of our largest departments. We increased inventory levels in some other departments to compensate for the planned decrease in tops.

While sales in these departments increased year over year, their combined increase was simply not large enough to make up for the shortfall in knit tops business. We have cost-corrected this category as we move into the back half of the year by introducing compelling fashion tops at opening price points and strong margins. In hindsight, we also understand we can sell many more units of fashion tops per style than we have sold in the past, and we will capitalize on this opportunity going forward.

In total for the first quarter, net sales rose 6% with comp sales increasing 4%, including a 28% increase in e-commerce sales. This was lapping an 8% comp last year including a 38% increase in e-commerce sales.

Gross margin declined 10 basis points driven by product cost inflation, which was slightly offset by B&O leverage. And our sales growth, along with SG&A leverage and reduced interest expense, drove a double-digit increase in adjusted earnings per diluted share to $0.47 from [$0.42] last year.

Highlighting our four pillars of growth, in our existing stores we continued to generate increased sales productivity in the first quarter.

In women's, our business was led by increases in woven tops, in denim, dresses, and jackets. Our customers loved our interpretation of color across our offering, especially in denim and other bottoms. We expect color to be an important trend for us to capitalize during the remainder of the year.

We saw year-over-year growth in some of our newer categories such as personal care and women's footwear. Going forward, we expect to continue to expand both categories, including a new women's fragrance launch planned ahead of holiday.

Also new for fall, we plan to introduce women's watches following our successful introduction of men's watches last fall.

In men's, we were particularly pleased with the strength of woven tops, suits, shorts, and accessories. We continue to see a trend toward dressy, as evidenced by double-digit increases in suits and in woven shirts, complemented by continued strength in our ties business.

Based on early indications, we are excited about current results of colored jeans and pants. We are currently delivering them in depth and are in a good position to support demand.

In addition, we generated excitement and saw strong increases in new categories within our men's business, such as watches, which are currently in 50 of our stores and will be expanded to a majority of our stores this fall. In personal care, Loyalty, our newest men's fragrance, debuted as our strongest new fragrance launch ever.

Turning to marketing in the first quarter, we saw a very strong response to our spring marketing efforts, including our 28-page catalog which was mailed to 7.2 million homes in the US. We also continue to optimize our marketing strategies in magazines and outdoors, while enhancing our TV advertising through strategic placement of commercials on select networks and programs that appeal strongly to our key demographic.

During the quarter we unveiled our new loyalty program, Express NEXT, across our store base following our successful pilot last fall. While early, we are very pleased with the response to the program. In fact, sign-ups have exceeded our expectations.

We expect the new program to increase our connection with the target demographic, leading to increased shopping frequency and overall share of apparel spending as points accumulate over time. We believe our program is unique in the marketplace, and captures how our customers shop and interact with fashion in their daily routines.

Points are earned both in-store and online at Express.com, and shoppers can accumulate additional reward points as they engage with the brand bias via social media platforms. This way, points are not only earned when she buys her favorite pair of Editor pants, but also when he posts about the 1MX shirt on Twitter.

As it relates to our second growth pillar, we saw robust growth in e-commerce sales, which rose 28% in the quarter following a 38% increase in the first quarter last year. This was driven by balanced growth across most categories, with notable strength in denim, dresses, casual woven tops, and dressy woven pants. We remain on track to re-platform our website by the end of the summer, which will give us more creative control, enhance our site performance, and allow us to provide more customization over time.

We also expect to create a more seamless experience between our stores and e-commerce site, with improvements that support online sales from our stores' point-of-sale terminals. We continue to receive industry recognition in e-commerce, recently achieving a ranking of 102 in the 2012 Internet Retailer Top 500 retail website list, jumping from 124 in 2011.

We advanced our third pillar by continuing to open new stores. During the quarter we opened four new stores in our new design and format in the United States, while closing seven existing locations. Most of the closures were either dual gender conversions or as a result of displacement due to mall redevelopment.

At quarter end, we operated 606 stores; 600 in the United States and 6 in Canada. For the year we remain on track to open 30 new stores, including 7 stores in Canada, while remodeling 15 stores in our new store design and closing 12 existing locations.

We continue to believe our new store format will allow us to increase our sales productivity as we more prominently showcase our four end uses and promote [out] (technical difficulty) dressing, while increasing our space devoted to accessories in an easier-to-shop and more powerful store layout. At year end, approximately [7%] of our stores will be in our new store format.

Moving to our fourth pillar of growth, we made progress on our international expansion goals with the recent signing of a new international franchise agreement covering multiple countries in Latin America. As we shared with many of you during our Analyst Day in March, we are intently focusing on capitalizing on our $600 million long-term international expansion opportunity, and believe we have a highly talented team and the disciplined strategy to achieve our goals. We continue to believe our brand, which targets 20- to 30-year-old demographic across all end uses, makes us uniquely suited for international expansion.

Our assortments always have been influenced and inspired by an international fashion aesthetic. In addition, we already serve a diverse international customer base in our US stores, and as evidenced by our tourist and border stores, as well as our current international stores through our arrangement with Alshaya in the Middle East, we are serving these customers very successfully. We continue to believe our three-pronged approach that includes Company-owned stores, joint venture relationships and franchise stores will allow us to penetrate key markets while successfully managing country risk.

As part of our international strategy, we shared with you plans to open 2 flagship locations this year, one in San Francisco and the second in New York. While we had anticipated these locations would open ahead of holiday 2012, we now plan to open both flagship stores in fall 2013, possibly sooner for San Francisco.

In San Francisco, the landlord experienced a delay in delivering possession of the space to us due to legal proceedings between themselves and one of the vacating tenants. While there is no definitive timetable on when this dispute will be resolved, we currently hope to start construction on this space sometime in Q4 of this year.

In New York, we had identified a location we were very satisfied with. However, a much stronger location became available which we are even more excited about. And we are very pleased to be able to tell you that we are in the very final stages of consummating a lease for this location on Broadway in the heart of Times Square.

This site will not only provide us with greater operational flexibility, but it will provide us an outstanding venue to showcase our brand. This new location will include prominent signage which will allow us to showcase the Express brand to the approximately 40 million tourists who visit Times Square each year; the 1.9 million people who walk through Times Square each day; and the 30,000 people who work there.

While the choice of this different location will mean a delay of approximately 10 months in opening this flagship store, we are extremely excited about the new location and its appropriateness for our brand and customers. Paul will discuss the implications of this change in location when he reviews our financial results.

In summary, I am pleased with our solid start to the year and equally optimistic that our strategies will position us for sustained positive growth over the next several years. Over the course of 2012 and longer term, we will continue to focus on approaching historical sales volumes across our four end uses; developing greater customer engagement and increasing sales through the introduction of our new loyalty program; continuing our strong momentum in e-commerce, which will benefit from the upgrade of our e-commerce platform this year; delivering on our new store expansion and remodel plans in an exciting and proven design layout; and accelerating our international growth.

We remain confident in our strategies and expect another year of growth and accomplishments in 2012 towards our long-term objectives. Now I would like to turn the call over to Paul to review our first quarter results and outlook in more detail. Thank you.

Thank you, Michael. Good morning, everyone. I'll begin by reviewing the detail of our first-quarter results and then provide our outlook for the second quarter and full-year 2012.

For the first quarter, net sales increased approximately $28.6 million, or 6%, to $496 million as compared to $467.4 million for the first quarter of 2011. Comparable sales increased 4% for the quarter following an 8% increase last year. Our e-commerce sales grew 28% and represented 10% of our business compared to 8% in 2011.

Gross margin increased 6% to $188.8 million. Higher product costs drove a 70 basis point reduction in merchandise margin, but was largely offset by 60 basis points of buying and occupancy leverage, resulting in a gross margin rate of 38.1% of net sales, essentially flat with the prior year rate of 38.2%.

Selling, general and administrative expenses totaled $114.2 million, or 23% of net sales. This compares to $109.5 million, or 23.4% of net sales in last year's first quarter, which included $600,000 of non-core cost related to the secondary offering completed in April of 2011. We achieved a 40 basis point reduction in SG&A, even as we continued to invest in our business.

Solid sales growth and leverage and SG&A led to a 10 basis point expansion in our operating margin. Operating income increased 7% to $74.6 million or 15% of net sales from $69.4 million, or 14.9% of net sales in the first quarter last year.

Interest expense totaled $4.8 million. That compares to interest expense of $11 million in the first quarter of 2011, which included a $3.5 million loss on extinguishment of debt related to the repurchase of $25 million of senior notes.

Our income tax expense was $27.9 million, representing an effective tax rate of 39.9% compared to a tax expense of $23.4 million in the first quarter of 2011 at an effective rate of 40.1%.

Net income for the first quarter was $42.1 million or $0.47 per diluted share. This compares to net income in the first quarter of 2011 of $35 million, or $0.39 per diluted share, which included the following non-core operating costs after tax -- $300,000, or $0.01 per diluted share related to the secondary offering completed on April 6, 2011; and $2.1 million, or $0.02 per diluted share related to the repurchase of $25 million of senior notes.

For the first quarter of 2011 on an adjusted basis, excluding the non-core operating costs I just mentioned, earnings per diluted share were $0.42.

Turning to the balance sheet, our financial condition remains very strong. We ended the first quarter with cash and cash equivalents of $180.4 million, compared to $180.8 million at the end of the first quarter last year.

Total debt declined by $143.9 million to $198.6 million from $342.5 million at the end of the first quarter last year. At quarter end, no borrowings were outstanding under our revolving credit facility.

For the first quarter, capital expenditures totaled $16.9 million compared to $12.3 million in the first quarter of 2011. Considering the investments we have made in the business and the significant reduction in debt since this time last year, our cash position being equal to a year ago is a real testimony to the strength of our operating model.

Quarter-end inventory rose 13.7% to $196.5 million compared to $172.8 million at the end of the first quarter last year. This increase versus our sales growth rate reflects the timing of certain deliveries; higher product costs; our funding of growth categories such as shoes, watches, and personal care; and units to ensure we provide property inventory levels for our rapidly-growing e-commerce business.

Inventories per square foot increased 8% compared to the first quarter of fiscal 2011. We will maintain our strict inventory discipline and expect to end the second quarter with inventory more in line with our sales trends.

Now I'd like to turn to our guidance. Based on our first-quarter results, our expectations for the second quarter and the shift in the opening of our two flagship locations, we have modified our guidance. For the second quarter, we expect comparable sales to increase in the low to mid-single-digit range, which compares to a comparable sales increase of 6% in the second quarter of last year.

Our effective tax rate is expected to be approximately 40% for the second quarter of 2012. Net income is expected to be in the range of $13 million to $16 million, or $0.15 to $0.18 per diluted share on 89.4 million weighted average shares outstanding. This compares to adjusted net income of $14.9 million, or $0.17 per diluted share for the second quarter of last year.

Our second-quarter guidance includes incremental pretax costs of approximately $5 million related to the acceleration of rent related to our New York flagship location, our international expansion plans, and acceleration in stock-based compensation expense due to the issuance of performance-based share grants for our senior leadership team. This is $1 million higher than our previous expectation for these costs when we provided guidance in our Q4 2011 call.

Now we'll turn to our full-year guidance. As discussed previously, the fiscal year ending February 2, 2013 contains a 53rd week. This 53rd week is included in our fourth quarter and reflected in our guidance.

We estimate that the 53rd week will represent approximately $32 million to $35 million of incremental revenue, and incremental diluted earnings per share of approximately $0.04 to $0.05.

For the full year 2012, we currently expect comparable sales to increase in the low to mid-single-digit range. This compares to a comparable sales increase of 6% in 2011. Our overall sales and net income assumptions reflect the expected delays in the opening of our New York and San Francisco flagship stores.

We expect our effective tax rate to be between 39.9% and 40.1%. Net income is currently estimated in the range of approximately $160 million to $169 million, or $1.79 to $1.89 per diluted share on 89.6 million weighted average shares outstanding. This compares to adjusted net income of $147.1 million, or $1.66 per diluted share last year.

During the last earnings call, we provided direction with respect to three distinct expense items included in our guidance. These included, all on a pretax basis, expenses associated with our planned international expansion; pre-opening expenses for our 2 planned flagship stores; and accelerated stock-based compensation expense driven by the conversion to performance-based share grants for our senior leadership team.

The impacts from our investments in international and expansion, and accelerated based stock compensation have not changed. I want to provide you with updated direction regarding the flagship expense, given the change in location and timing.

As discussed earlier, the New York store opening is delayed due to the change in location. While infrequent in occurrence, certain aspects of this new lease triggered accounting standard number 840-40-55, the effect of lessee involvement in asset construction, which in this situation, requires the Company to be considered the owner of the new flagship building for accounting purposes only. This requires rent expense recognition, despite the fact that we have not taken possession of the space.

As a result, we will have additional non-cash rent expense as soon as the landlord begins work repairing the space in June of 2012, despite the fact that will not take possession of the space to start our own construction until spring 2013. For 2012, this obviously pulls non-cash rent expense into Q2, Q3 and Q4 with no benefit of offsetting revenue as previously expected in Q4. Accordingly, these expenses have been reflected in our current guidance.

I have already mentioned that $5 million related to these three items is included in the second-quarter guidance. Approximately half of those expenses will impact gross margin and half will impact SG&A during the quarter.

In the third and fourth quarters, we expect these investments on a pretax basis to approximate $7 million and $6 million, respectively. Approximately 60% will impact gross margin and 40% will impact SG&A in each quarter.

While we are not introducing Q3 guidance, please note the following when modeling that quarter. We expect SG&A as a percent of sales in Q3 to normalize and approximate Q3 2010 levels at 24.7%. This is primarily driven by the incremental expenses we just discussed, as well as a shift in marketing dollars back into Q3 from Q4 last year, as we referenced on our Q4 call in March.

In addition, we also expect to incur incremental SG&A costs related to our investments in IT and e-commerce, and do not expect the anniversary the favorability from last year's Q3 stemming from significant open headcount and a one-time tax infringe true-up.

Turning to our store expansion plans, for the second quarter of fiscal 2012 we expect to open 10 stores in the United States and close 4 stores. For the full year, we continue to expect to open approximately 30 new stores including 23 in United States and 7 in Canada. We plan to close 12 existing locations, primarily related to dual-gender conversions and mall redevelopments, and we expect to end the year with 627 stores and approximately 5.4 million gross square feet in operation.

Capital expenditures through the year are now expected to be less than originally planned, given the two flagship stores that will now occur in 2013. As such, capital expenditures are now expected to be in the range of $103 million to $108 million.

As outlined on our -- excuse me -- fourth quarter call, the additional capital versus prior year is driven by more new store openings than last year, renovating approximately 15 existing stores in our new design format, and IT costs related to a new platform for the front end of our e-commerce business; an upgraded allocation system; and a new general ledger system to support our international expansion. Finally, we expect to generate positive free cash flow.

And with that, I'll turn the call back over to Michael for some closing remarks.

Thanks, Paul. In conclusion, we had a solid start to the year. And while we have modified our short-term outlook, we are pleased with the progress we are making towards our annual and long-term growth goals. Our brand remains strong with our customers and we are expanding our reach within our demographic, as we consistently present strong selling assortments and reach new customers with high impact marketing.

Equally exciting, we believe, is that the strategies that we are implementing this year with regard to our loyalty program, our new store design, the upgrade of our e-commerce platform, and our international expansion have us poised to take advantage of even greater rates of growth and profitability in the future.

We look forward to sharing with you our progress towards our goals as we move through the year.

Now I'd like to turn the call over to the operator, so we can begin the question answer portion of the call.

(Operator Instructions). Neely Tamminga, Piper Jaffray.

Michael, can we dip a little bit more into this knit tops issue? Just wondering is that the primary change in terms of that delta of going from a mid-single-digit cadence to a low to mid-single?

Yes, it is.

Okay. (multiple speakers)

It's both the bad news and the good news, the bad news being it was a big decrease, but the good news being that it is so specific. The rest of the business is really quite healthy.

So, what we have discovered about that business is despite the fact that we've dropped heavily in it, what we've discovered is we do have opportunity within that category to sell fashion T-shirts in much bigger depth than we had believed we could. When we basically abandoned the basic T-shirt business because of the low retail and the low margin, and the fact that competitively we were just not there with the less expensive purveyors, we really did not believe we could approach those kinds of units per style that we now know we can.

So that going forward you're going to see fashion tops at opening price points, and you're going to be seeing greater depth within that category of particular styles. Had we come close to our plan, the total picture would be very different, because we did solidly well in all of the ready-to-wear categories. When you put dresses and pants and woven tops together, it was really quite strong.

So Michael, related, though, to that, it seems to me, especially on knit tops, that the leadtimes in fact are certainly shorter than maybe a tailored jacket and what have you. So, can you give us a sense as to how we should be thinking about the timeline of your ability to really build into this with respect to volume and when it's going to matter?

Sure. Luckily, the portion of our knit top business going forward into fall is a much smaller percentage than it is in spring. So there's not that much at risk. But you should be seeing this new formulation within two months.

And listen, this is Matt. Basically we go back in hindsight and look at what we did. As Michael stated, we violated one of our guiding principles of taking a balanced approach to the business. And we planned knit tops down significant double digits for the spring season based on the strategy of getting out of these commodity-type items, not understanding that we could sell more of the fashion knit tops.

And in doing so, when we planned the inventory down in knit tops, we put that inventory into several other categories in the business. And as Michael stated at the beginning of his comments, we simply didn't have enough volume in the other categories, while they were good, not enough volume to make up for our biggest category in the spring season, which is knit tops.

Because of that, there will be some liquidation of inventory in Q2 as we get out of some of these pockets of inventory where we shifted that inventory from the knit tops into some of these other areas. And that is reflected in the guidance we provided.

So, if I may, just one more just to wrap this up to the P&L for Matt, for Paul. Can you give us a sense of what maybe -- obviously there's going to be a gross margin liability tied to Q2, and that's certainly implied in your guidance.

But as we peek around the corners of fall, would we be thinking we can get some normalization? I mean comp prices are hitting at an all-time low as well right now, so how should we be thinking, generally speaking, about the gross margin line items in the back half. Thanks.

So, Neely, I think you're hitting it -- you're nailing that we should expect some normalization in the gross margin as we get into Q3 and Q4. For Q3 we're looking at product costs on a rate basis that are about flat with prior year. And then in Q4, as we've spoken about, we would expect to see a little bit of benefit in our product costs as we get into Q4.

Yes, mid-single-digit decreases in product costs in Q4.

Thank you, gentlemen. Good luck.

Thank you.

Thanks, Neely.

Thanks, Neely.

Roxanne Meyer, UBS.

Just to continue on that conversation with knit tops, I guess what's changed in the business that you think you want to go after an entry-level price now, knowing that that's something that you've really stayed away from?

Well, when we say entry level, it's not the entry level of the basics. It's entry-level for fashion, which is a significantly higher retail than the basics were. So, entry-level is a very relative term for us. And I'm sorry if I confused you about that.

But the thing of it is, is that in terms of the basics, you all know who's getting that business. And it is not anybody that's got a solid, sort of multi-category brand. It's the lower price purveyors. It is the pile it high and watch it fly. We did that for many years. We did well at it. And it's no longer our thing.

Okay, great. And is there way to think about how much comp you potentially left on the table as a result of not being there in the knit tops category?

Yes, I'd say about between 1% and 2%.

Of comp.

Okay, great. And then as it relates to the guidance update, obviously, the low to mid-single-digit comp range is part of the adjustment. Did you say that the update was really driven by this transition that you had gotten out of knit tops, and now you needed to go back into knit tops? Or is there anything else that had an impact on the revised guidance for the full year?

So, basically there's a couple of things that had impact on the revised guidance. The first thing was the fact that, our Q1, we flowed that through to the year. Q2 is also included there, based on the fact that we're going to have to liquidate some excess inventory based on the inventory that we put in other areas, other than knit tops that I just talked about.

And then the third thing really is there was about $0.03 associated with this accounting treatment for the New York flagship store. This non-cash rent accounting treatment is a piece of it as well, where it's unfortunate that we have to take that. We're basically not even taking possession of the space for this new flagship store, which should be very exciting, but we are having to pay -- or record expense rent on that throughout the remainder of 2012.

We'll take possession of the space in March of 2013. It's an interesting accounting rule that obviously we need to follow. But the other piece is we're reflecting the current trend in the business.

As Michael said, you look at the fall receipts that have come in, they are reading very, very positively right now. We would hope that we could beat that guidance at the remainder of the year, but we're putting guidance out there that we feel very comfortable with, so that we don't disappoint again.

Okay, great. Thanks and best of luck.

Thank you.

John Morris, BMO Capital Markets.

Thanks. Let's see, Paul, can you share with us, so we can understand the quality of the quarter a little bit better, the transaction and average ticket metrics, if we can see that; what the change has been there?

Yes, so the comp is really, John, being driven by our average dollar sales again this quarter. From a traffic standpoint, we were pretty much flattish in terms of traffic, maybe a little bit up, little bit of an upside there. But really the comps are being driven by ADS.

Okay. And then Michael, can you talk a little bit about your performance in the quarter in bottoms? And particularly with an eye towards -- we know that colored denim was pretty strong, but other bottoms as well as a little bit of discussion about your core denim business and how that's been performing?

By bottoms, you are you talking about across the whole business, men's and women's. Is that correct?

Yes, I guess I was leaning a little bit more towards women's. I know the men's business has continued to be pretty strong, so maybe a little bit on both, but with an eye towards women's, yes.

Okay, in terms of bottoms, it's a really interesting question. Clearly, jeans were ahead in women's. And they were ahead based on two things. They were ahead based on our color and ahead based on our Extreme Stretch, which is a new fabric we started last year in a minor way and are currently in it, in great strength, and will be in it even stronger.

The good thing about the Extreme Stretch is it captures the denim, the actual blue denim business in a very new way. We believe that color goes forward in women's.

The other bottoms in women's were up quite good. Shorts were good in women's. Shorts are terrific in men's. And the color has added to both of those categories.

Skirts in women's were very good in -- at the dressier end; much better at the dressier end than the casual end. We did not wind up with a very good casual skirt key item where we had very good dressy skirt key items.

In men's, we are still struggling a bit on the denim side. Doing great in dressy pants; really, really great in dressy pants and great in suits, which is part and parcel of that.

I think that, as a few of you have noted in constructive criticism, we were not in the color in men's as rapidly as perhaps we should have been. And based on what we have received so far, and based on the fact that we're going to be in it much stronger, it has performed wildly well in both pants and in denim.

What I should add here, because I think it's important, is the last time casual pants were important in men's for Express, it was all based on color. When paratrooper pants were great, it was all color. When our X-pant, which was a drawstring pant, was great, it was all color. And that's a department that went from about $100 million to just about nothing in the past few years.

So, we see upside there, John. We see upside in the bottoms significantly, because of the color situation.

Great, thanks. Good luck for fall.

Thank you.

Janet Kloppenburg, JJK Research.

Michael, if we could just talk a little bit about the quarter and the month-by-month trends, and when you saw this struggle with the knit tops business to begin -- when it began, that would be helpful. And I think you're assuming that this distortion in knit tops will continue through the second quarter, but I'd just like -- I'd love some clarification there.

And for Paul, I was wondering about the reported EPS number of $0.47. Is that clean of any one-time charges associated with this change in opening schedule of the flagships? And then I have a follow-on. Thank you.

Do you want to go first?

Sure. So the EPS number is clean, Janet.

And it coming in below consensus just reflects the fact that comps were weak because of the knit top business, is that right?

That would be correct.

Okay. And Paul, just to stay on that then, your guidance change on the annual number from $1.84 to $1.97 down to $1.79 to $1.89, that $0.05 to $0.08, I'm wondering, is at all related to this change in the opening schedule of the flagships and the associated rent expense? Or is there some caution there with regard to the comp and margins?

Yes, so about $0.03 relates to the shift in the dates of the opening of the flagship. And there are, of course, a couple of pennies refer to one, results, and $0.01 to $0.02 for our Q2 expectations.

As well, we've moderated our overall sales guidance to the low to mid-single-digit range. So altogether, that's what's making up the change, Janet.

Okay, and just one more question on that. The guidance for the second quarter, if you add back the $0.02, am I at -- legitimate to add that $0.02 to your stated guidance?

And I'm not sure I understand your question. $0.02 for --?

For the pre-opening expense, is that correct, or not?

No, we're actually going to have more rent expense now than we had before. It is somewhat counter-intuitive. We're not opening the two -- (multiple speakers)

No, no, I understand that. But I think your guidance was $0.15 to $0.18 for the second quarter. My question is, adjusted (multiple speakers)

It's just for the second quarter, you talking about (multiple speakers)

-- the $0.17 to $0.20, it is that a legitimate analysis?

It's about $0.03 for all those expenses, Janet; for our investment in international, for the stock as well as the stores. We haven't broken out each individual piece.

Okay, thank you. And just, Michael, if we could talk a little bit about the monthly (multiple speakers)

Sure. As you remember in our Analyst Day, we did talk about the problems in knit. In terms of the way the season plays out, as we got into April and May when the knit business is always bigger because you're in really the height of summer business, it became a bigger burden on the total comp, quite clearly.

Going into June, which is a very promotional month, we have enough inventory to do better than we have currently done. And we did some corrective buying in March, which will affect our inventory in June in terms of things to sell. But going forward in the knit tops into fall and holiday, it's an important part of our business, but not nearly as important as it is in spring/summer.

So we figure that the downside there is becoming much more minimal than it had been.

Janet, when we talk about our whole testing strategy, when you look at the knit tops, we bring in small quantities across the board in November and December for spring; get reads on those. We get those back in, in bulk quantities in March, April, May for the heart of the selling season as we've talked about in the past.

So, really, this trend emerged -- we talked at the Analyst Day about the fact that we were moving away from the commodity basic tops into fashion knit tops, as we have on a couple of other calls, but this trend really emerged in late March. We had a solid February. It emerged in late March and certainly into April and May as well. And that's why we have the guidance for Q2.

The spring inventory will be run out in June with a little bit left in July. And we start to get our fall receipts in, which Michael talked about, in June and July for the fall knit tops in small bulk quantities. So that's where we'll start to see some of the correction.

Okay, but when you say you have you'll have enough for the sale, do you mean you'll have some of these lower price knits in time for the sale or you will not?

It's not so much that they're lower price, Janet; it's that they are promotionally priced.

Okay.

But there's a difference there.

But will you have those in time for the June sale, Michael?

Yes, some of them, yes, because we went back into some of them as we checked them very strongly early in the season. But it's not going to be significant enough to move the category significantly. We will be doing, I believe, better in that category in June than we did in May.

Okay, great. Thanks and lots of luck to you.

Thanks, Janet.

Richard Jaffe, Stifel Nicolaus.

Thanks very much. A quick question on international and the franchise. You mentioned the Latin American partnership, and wondering how the Middle Eastern initiative is playing out, and if we can get a sense of timing on when we can actually see revenues coming from these relationships. And a second part of that, do you envision e-commerce as being part of this initiative, either into the Middle East or Latin America?

Yes. So from a Middle East perspective, that business is very, very strong. As we talked about at the Analyst Day, we had strong -- very strong double-digit comps over the past year with the Middle East. We're now lapping those with strong double-digit comps on top of those. So the Middle East business is alive and very healthy.

From this new partner that we just signed last week, we're very excited about it. It's for a multi-country agreement that we have in Latin America. We're still finalizing the communication plan with their team and we should have a press release out on that in the next few weeks, giving more details about this.

But it's very exciting. We should have a couple of stores open with this franchisee in Q4 of this year, and then obviously continue to open more stores next year, as well.

From an e-commerce perspective, we will eventually get into the e-commerce business internationally. Right now we ship to 60 countries fulfilling out of the US, which is not optimal.

We will certainly have e-commerce businesses in places where we go deep with Company-owned stores. From a franchise perspective, we're looking at that as well, in determining the appropriate approach to conduct fulfillment in those geographies.

Thank you very much.

Kimberly Greenberger, Morgan Stanley.

Great, thank you. Michael, I wasn't sure what you meant about the current trend of the business during the Q&A session. Did you mean to say that the current trend of the business is slower or better? And you were specifically relating it to fall goods. I'm wondering if you could --

No, I'm talking about the whole trends of the business. When you look at dresses, for argument's sake, or when you look at woven tops, it's really very, very good. I think the bigger the knit top piece becomes as a percentage of total, the more difficult the total comp has become.

In terms of early receipts, as Matt has said -- and by early receipts I'm talking about the things that we plan to do big business on in Q3, we're doing quite well there. So, despite the fact that we would have loved to have report better, we're not pessimistic about going forward.

We beat every key statistic from last year, even with a really difficult time in what is one of our very biggest categories. So in terms of the trends in the rest of the business, we're quite happy with it.

Okay, that's helpful, Michael. Thank you. And then just reflecting back on Q1, did you have an opportunity to try to work on a fix that knit top business during the quarter? Or do you have lead times in the business that would even really allow for a mid-quarter adjustment like that?

No, no, we could have adjusted. And I'll tell you -- what we have been saying now for about a year is the big, big upside in our current go-to-market strategy is being able to ingest the information we get, because we get a lot of information. But we don't yet really know how to maximize the impact of that information.

We saw what was happening, but we didn't really realize how deeply we could sell a fashion top. We knew what was good. We just didn't buy enough of them.

And the fact of the matter, Kimberly, is that because we deliberately made this shift away from knit tops, we didn't necessarily follow the indexing that we normally would have.

The test results tell us whether the items are good or not. We put the inventory into those buckets at lower levels. And then we looked at the test results from the other areas that told us what the right styles were; put more inventory into those areas. Those other areas were up, just not enough to make up for the biggest category in our business being down.

Okay, thank you, that's helpful.

Lorraine Hutchinson, Bank of America Merrill Lynch.

Thank you. I just wanted to follow up on some of the gross margin questions from earlier. Product cost and inflation has been something you've been able to offset with price increases, it seems like up until this quarter. Can you just talk about what the changes were this quarter, and then how we should expect the cadence of your product cost to look going forward?

Lorraine, our product costs were up honestly a little bit more than we expected. We've been talking about mid-single-digit increases in our product costs. Actually, on a rate basis, came in a little bit higher than that. So we weren't able, with pricing, to offset everything.

As we look ahead, we'll see -- we expect to see product costs improve quarter over quarter as we go throughout the year. In Q3 we would expect to see roughly flat product costs on a rate basis compared to prior year, and in Q3 -- excuse me, Q4, a modest improvement; probably low to mid-single-digit improvement in product costs in Q4.

The other issue here, Lorraine, in terms of predicting it, is that based on our open to buy system, we leave a lot of money open. So, a lot of times, that money goes into places that we didn't anticipate it going to. So it becomes a mix issue in terms of predicting product cost increases.

Thank you.

Eric Beder, Brean Murray.

Good morning, it's Eric Beder, Brean Murray.

Two things, I want to talk about to you about the longer-term implications of what the NEXT card means for you guys going forward, in terms of when you can start really reaping the benefits of that. And how do you expect that to change your ability to satisfy your customers even more?

And what are the advantages of taking in your e-commerce and running that directly? And how do you see that playing out?

So we think there's significant upside to both of those, Eric. If you take a look at our NEXT program that was rolled out at the end of Q1, we talked about the fact that this is really going to take some time to ramp up. We talked about that during the Analyst Day, where it's going to be really a Q4 thing. Q1 of next year we believe we'll see a bigger impact.

The sign-ups have been ahead of what we originally anticipated with the program when we rolled it out. We already have 2.6 million customers signed up with the NEXT program. 1.4 million of those customers were converted from the old program, but we've also signed up 1.2 million new customers.

Once they sign up for the program, what we have learned with the pilot is that it does take time for them to start earning points, understanding the rewards that they get. And once they start cashing those rewards in, you start to build some momentum. That's why we're saying it will probably look more like Q4, Q1 where we'll start to see an impact there.

And obviously, we're still aggressively signing up new customers on a daily basis. So, from that perspective, we're very excited about the NEXT program and think it will pay long-term dividends for the business.

And I'm sorry, the second part of your question was --?

The online business, how do you look upon that, taking it over this year? How is that going to impact you?

Yes, so as we talked about earlier, that we are re-platforming our e-commerce business, taking it from a third party vendor on the front end, bringing it in house. That re-platforming will be complete in August.

What we did say at that time, though, was that this re-platform, the first step in this re-platforming is that we want to take the existing capabilities of the platform and put them into our new standalone platform and stabilize that, so that we can get through holiday, because we want to make sure we don't have any issues, obviously, through holiday with a brand-new, overall platform. And then we will make some investments in Q1 and 2013 to start adding some of the additional capabilities of the e-commerce platform that should help the e-commerce business to continue to ramp up at an aggressive pace, as it is currently doing today.

Thank you.

Betty Chen, Wedbush Securities.

Thank you. I was wondering, Michael, if you could give us any color around what other categories got the incremental investment instead of knit tops, and how we should think about the potential gross margin impact from the clearance of some of those liquidations in the second quarter.

And then I was also hoping to shift gears for a moment and talk about Canada. What can you share with us in terms of the Canadian stores and how they've been performing? Thank you.

Okay, in terms of categories that got significantly more inventory, I think on top of the list are some of the excessive categories -- shoes, personal care, categories like that. We did have additional investment in casual dresses, which paid off very, very well.

We had additional investment in certain bottoms, in shorts. We had additional investment in woven tops in both casual and dressy. And both were trending very well.

As we said, perhaps we -- we felt we could have done more, but we did quite well in terms of increases in these categories, just not enough to counterbalance as much as we dropped in the knit tops.

But having said that, by the end of the quarter we were quite far ahead of last year in total, in dollars. Let me just look, I have that here somewhere. At the end of the quarter we were $29 million ahead of last year.

So this is not -- we're not talking about an excuse for dropping against last year. What we're talking about is not picking up as much as we felt we could.

Right. And from a gross margin standpoint, Betty, I think breaking it into a couple of pieces, from a merch margin standpoint I would see deterioration in Q2 that approximated, maybe a little bit more favorable than what we saw in Q1. We will get a little bit of a deleveraging Q2 in terms of our B&O based on the investments that we talked about making, particularly as to the expenses that are related to the flagship stores that we're forecasting.

And Betty, for your final question, as we take a look at Canada, the Canadian stores -- when you compare those to the US stores that we have, where we have a high-90%s brand awareness in the United States, the Canadian stores have much lower brand awareness, obviously. They are ramping up slower than the US stores typically ramp up.

However, as we capture the customers and have them in our database, those customers are performing as well as the US customers are performing. So we're ramping up the customer capture in Canada to -- and working on capturing more of the customer data from that perspective. And that should certainly help that business a little bit.

When you take a look at other areas where we also have lower brand awareness, when we first opened our stores in the Middle East, they did well. But now they are, as we talked about earlier on the call, ramping up at significant double-digit increases year-over-year.

And the same phenomenon was true when we opened our stores in both [Al Mawana] and Puerto Rico, outside the mainland US where there wasn't as much brand awareness as well. Those stores started out a little slower and then they are more than catching up at this point. And also in those two stores or three stores, we're seeing significant double-digit increases in the second and third year of operation.

Okay, great. Thank you so much and best of luck.

Thank you. Okay and the only -- sorry, next question, please.

Marni Shapiro, Retail Tracker.

Michael, I never want to hear the word paratrooper pants again, please.

(laughter) But you do remember them. And they were in lots of colors.

I remember them. I remember Capezio pants, too, and I don't want to see those again, either.

I was just curious, not to beat the dead horse, but I'm going to, because I'm wondering. There were items in your store on the fashion side on the knit tops that were selling. And I'm curious if there were things like sparkle tanks and back detail tops that were selling, where basic tees you didn't have enough of, and so that's where you lost the volume.

And then if I think forward into the fall season, knits translate into sweaters. Should I be concerned about sweaters? Or has your sweater business remained strong in spite of the knits, because the knits are specific to just the basics?

Okay, a good question. Yes, the sparkle tanks are very, very good. But we have a history with those, so we bought enough of them. I don't feel we lost any business on the sparkle tanks.

In terms of the interesting back treatments, you're talking about those crochet things, the knot things, they were very, very good. And we did not have enough of those. So it's yes and no in terms of that question.

In terms of the sweaters, we still have to see what's going to happen in the month of June with new receipts, and we're getting them in right now. That will be a much better question to ask me in a couple of months.

All right, great, guys. Congrats and good luck.

Thanks, Marni.

The one thing I also want to reiterate, to make sure we get this point across in the call as well, we did take our guidance down for the full year as we talked about. But also, it's important to note that we do have $19 million of investments that are not generating operating income.

So, when you adjust that out of our -- adjust out of our base business, even with the decrease in the guidance that we provided for the full year, the base business is still generating pretty significant operating income. And as Paul reiterated in his remarks, that's driven by the international investment.

We will generate some revenue with this new franchise that we did sign last week. But there are more investments that offset that revenue, given it's only two stores that we are opening in Q4. And then the flagship rent is certainly a large piece of that, and also the performance-based stock comp.

So when you put those 3 pieces together it is $19 million of expense that we're adding to our P&L. And you take in that in conjunction with the guidance, the business is still, overall, we believe, in a healthy place.

So, with that, I think that will be the last question.

Was that the last? Okay.

Thank you again for joining us. We look forward to seeing many of you at upcoming investor conferences in the month of June. Thanks.

Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time and thank you for your participation.