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Operator
Good afternoon.
My name is Christy, and I will be your conference operator today.
At this time, I would like to welcome everyone to the second quarter 2008 Kohl's earnings conference call.
All lines have been placed on mute to prevent any background noise.
After the speaker's remarks there will be a question-and-answer session.
(OPERATOR INSTRUCTIONS).
Statements made on this call, including projected financial results are forward-looking statements that are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected in such forward-looking statements.
Such risks and uncertainties include those that are described in item 1A in Kohl's annual report on Form 10-K and as may be supplemented from time to time in Kohl's other filings with the SEC, all of which are expressly incorporated herein by reference.
Also, please note that the replay of this call will be available for 30 days, but this recording will not be updated.
So if you are listening after August 14th, it is possible that the information discussed is no longer current.
Thank you, Mr.
McDonald, you may begin your call.
Wes McDonald - CFO
Thank you.
With me today is Larry Montgomery, Chairman and CEO; and Kevin Mansell, President.
I'll start off reviewing our financial performance as well as some balance sheet highlights, and I'll turn it over to Kevin to talk about merchandising and marketing initiatives, and then Larry will wrap it up with our store-growth plans and our earnings guidance.
Sales for the second quarter were approximately $3.7 billion this year versus $3.6 billion last year, up 3.8%.
Year to date, total sales increased 2.6% to $7.3 billion.
Comp sales for the quarter decreased 4.6% driven largely by a lower transactions per store which decreased 4.4%.
Average unit retail increased 1.5%, but was offset by a 1.7% decline in units per transaction, resulting in an overall 0.2 decrease in average transaction value.
Year to date comp sales decreased 5.6%.
Average unit retail was flat to last year, and units per transaction decreased 1%, resulting in the same decrease in average transaction value.
Transactions per store decreased 4.6%.
From a regional perspective, the Northeast outperformed the company average for both the quarter and year to date periods.
The Southern regions, South Central, Southeast, and Southwest, continues to struggle as sales in states most affecting by housing issues, California, Arizona, Nevada, and Florida continue to be soft.
Our credit share was 44.6 for the quarter, an increase of approximately 270 basis points over the prior-year quarter.
Year to date credit share increased approximately 250 basis points to 44.6% as well.
Moving on the gross margin, our gross margin rate for the quarter was 39.6%, up 68 basis points from last year.
Year to date margin increased 30 basis points to 38.2.
The increases reflect strong inventory management, lower clearance levels, and higher penetration of both private and exclusive brands.
We would expect gross margin to increase 10 to 20 basis points over last year in the third quarter, and 20 to 40 basis points in the fourth quarter.
SG&A increased approximately 11% for the quarter.
As expected, this was faster than sales but lower than our expectations of approximately 12 to 13% over last year.
Year to date SG&A increased approximately 9%.
Credit expenses leveraged for the quarter and year to date.
Stores advertising corporate and distribution center expenses did not leverage for either period due to lower than planned sales, our continued desire to maintain a positive customer in-store experience, and on going efforts to drive additional traffic.
We would expect our SG&A expenses to increase 9 to 10% in the third quarter, and 5 to 6% in the fourth quarter.
The difference between the quarters is primarily due to having our 95 fall 2007 stores open for the entire third quarter versus one month last year.
Depreciation expense for the quarter was $133 million, and $263 million year to date, a 25% increase over both prior-year periods.
The increases are primarily due to new stores.
Depreciation is expected to be approximately $135 million in the third quarter, and $140 million in the fourth quarter.
Moving on to preopening expenses.
Preopening expenses were $6 million for the current year quarter versus $9 million last year.
Year to date preopening expenses were approximately $17 million in both 2008 and 2007.
The decrease in the quarter reflects the decrease in the number of fall openings; 47 in 2008, compared to 95 in 2007.
Preopening expenses are expected to be approximately $23 million in the third quarter, and $8 million in the fourth quarter.
Operating income for the quarter declined from $444 million last year to $406 million this year.
Year to date operating income was $678 million, compared to $790 million last year.
Net interest expense increased to $27 million for the quarter, compared to $11 million in the prior year.
Year to date net interest expense was $53 million, compared to $21 million the prior year.
The increases are primarily due to the $1 billion in debt we issued in September 2007.
Interest expense is expected to be approximately $32 million in the third quarter and $30 million in the fourth quarter.
Our income tax rate was 37.9% for both the current-year quarter and 37.7% for the year to date period.
We expect our 2008 tax rate to be approximately 38% for the third quarter and the year.
Net income for the quarter was $236 million, compared to $269 million last year, and year to date net income was $389 million compared to $478 million last year.
EPS for the quarter was $0.77 compared to $0.83 last year, and year to date EPS was $1.26 this year versus $1.48 last year.
Moving on to the balance sheet, we currently operate 957 stores compared to 834 stores at this time last year, and for your modeling purposes, gross square footage 84,942; an increase of 18.4% over last year, and selling square footage, 74,452; an increase of 17.2% over last year.
We had $461 million short and long-term investments at quarter end of 2008, compared to $36 million last year.
As a reminder, we reclassified approximately $425 million of auction-rate securities from short-term investments to long-term investments during the first quarter.
We also recorded temporary mark-to-market of $20 million, net of tax, through equity related to our long-term investments.
At the end of the quarter, inventory per store is down 15% per store to $2.7 million.
Our clearance inventory per store is down almost twice this amount on a unit basis.
This shows our commitment to being conservative, and our sales and receipt planning.
Moving on to fixed assets.
Year to date capital expenditures were $558 million, down 30% from last year's $801 million.
We continued to expect capital of expenditures of approximately $1.1 billion for the year.
We generated cash from operations of $874 million in 2008, versus $413 million in the first half of 2007, which more than funded our year to date capital expenditures.
Our accounts payable percentage as percent of inventory was 37.7 this year versus 38.4% last year.
During the quarter, we repurchased 2.6 million shares at an average price of $42.15.
Year to date we have repurchased 6 million shares of our stock for $261 million at an average price of $43.19, and for your modeling purposes going forward, I would use 307 million shares for the remainder of the year.
And with that, I'll turn it over to Kevin who is going to talk about our merchandising and marketing initiatives.
Kevin Mansell - President
Thanks, Wes.
Let me talk first about sales.
As Wes mentioned, comparable sales decreased 4.6% for the quarter, and 5.6% year to date.
All lines of business and all regions reported a decrease in comparable sales in both the quarter and year to date.
Accessories and men's outperformed the company for both the quarter and year to date periods.
Accessories was lead by sterling silver, watches and beauty.
Men's was lead by basics, particularly hosiery.
Children's performed with the company average and was driven by infants and toddlers.
Women's, footwear, and the home area underperformed the company for both the quarter and year to date.
In women's, missy, updated sportswear and basics were the strongest categories.
In footwear, children's shoes reported the strongest performance.
And home continues to be the most difficult line of business with soft home significantly underperforming the company.
Considering the uncertainty in the environment, we intend to continue our conservative planning assumptions on both sales and inventory levels going forward.
However, the existing reduction in inventory per store of 15% that we have already achieved puts us in an excellent position to flow fresh receipts as needed throughout the fall season.
We are building slight improvement in our expectations for sales in the fall, similar to our improvement in comp from the first quarter to the second quarter.
Our expectations for the fall season are for comparable sales to decrease 2 to 4%.
We expect the third quarter to be similar to the fall season in total, down 2 to 4%.
By month, August should be worse than the quarter, and September should be with the quarter, and October should be better than the quarter.
As always in the third quarter, weather could be a factor on by-month sales performance, particularly in our weather-sensitive regions.
Moving on to our merchandise initiatives.
We continue to be extremely pleased with the performance of brands introduced this spring.
Jumping Beans an opening price point children's private brand, targeted to provide value in children's apparel, is driving the infants and toddler business.
The Gold Toe business continues to help men's, women's, and children's basics outperform the company.
Our new Elle brand has been an overwhelming success.
It was part of the reason our Missy updated business achieved a positive high single-digit camp.
The expansion of our Food Network brand platform to include Bobby Flay has helped food prep outperform the rest of home.
And finally we're very pleased with our initial sales of our new Abbey Dawn line, a new junior's brand inspired by Avril Lavigne.
As a reminder, our exclusive partnership with Fila is just beginning to hit the stores in men's, women's and children's apparel, footwear, and hosiery.
We're planning a very broad September launch.
Our fall 2007 launches, Simply Vera Vera Wang, Elle, and Food Network, also continue to perform extremely well with both our existing and new customers and outperformed their plan for the quarter and year to date.
And in addition, our exclusive national brands of Chaps and Tony Hawk both had strong double-digit comp growth as did Apartment 9 in private brands.
As you can see, the customer continues to respond well to our new brand launches and their penetration continues to increase with substantial room to grow, particularly on the exclusive national brand front.
Our research continues to show that the acceptance is being driven by the high brand awareness each of these brands has when we launch them.
That success is embedded into our thinking for our planning of next year's launches of Dana Buckman, and Hang Ten.
For the quarter, our exclusive and private brands were up over 400 basis points in penetration to 42.7% of sales.
Primarily due to our exclusive national brands.
As Wes indicated, this had a favorable impact on our merchandise margin and we continue to expect that benefit for the balance of the year, given the growth that we plan in these brands.
Moving on to inventory, management, as we mentioned earlier, average inventory per store is more than 15% lower than last year.
Stronger than the highest single-digit decreases that we had originally guided towards achieving.
We accomplished that through more significant reductions in spring and summer seasonal transitional inventories.
As a result, some areas, like women's or men's sportswear are actually down substantially more than the total.
Basic areas like men's, women's, or children's underwear and hosiery are actually higher than last year on an inventory per store basis.
In addition, our clearance inventories are down approximately twice as much as our total inventory.
The team has done this in spite of also delivering a large number of new brands that we just discussed.
Looking forward, we would expect our inventory per store at the end of the third quarter to be down approximately low double digits per store.
In addition to carrying an overall lower level of inventory, we also continue to focus on flowing receipts in season as needed through our cycle-time initiatives.
This benefited us greatly in achieving both our inventory and gross margin goals in the second quarter and first half.
Markdown optimization continues to benefit us even with these lower inventory levels.
Our size optimization initiatives continue to develop, and we expect some benefit in the fourth quarter but certainly more in 2009.
As Wes indicated, for the third quarter, we would expect gross margin to be up 10 to 20 basis points over last year, with improvement in the fourth quarter of 20 to 40 basis points.
We believe this allows us to be flexible in our pricing as we expect the environment will continue to be extremely competitive.
Then finally, on the marketing front, from a marketing stand point, we're concentrating on four things.
First, continuing to support and grow our efforts by our Only at Kohl's brands, especially our exclusive national brands, these are all clearly working and have substantial opportunity to grow.
Second, continue to develop proprietary marketing handles seasonally to differentiate our marketing from the competition.
Our current back-to-school campaign around the connection between music and denim is a great example of that, and actually supports our first objective as well.
Third, continue to invest in those marketing vehicles that clearly have higher productivity in a time of increasing media costs.
Chief among those are direct mail and online marketing.
Print insertion will decline as a percent of our expenditures.
Finally and far most importantly, emphasizing value in all of our advertising.
Our inventory management strategies and our proprietary brand mix success have given us a unique position to be able to be aggressive in our promotional efforts, compared to competition, and still deliver improved gross margin.
We intend to use that throughout the fall and holiday season to our advantage.
From an in-store perspective, we're focusing all of our efforts on supporting our new life-style brands and presentation, and improving our customer service.
Our lower levels of inventory are definitely helping in this regard.
The customer service scores are up significantly year-over-year across all areas.
With that let me turn it over to Larry.
Larry Montgomery - Chairman, CEO
Thanks, Kevin.
We expect to open 46 stores in October and one in November, included in those 47 stores are our 1,000th store and 7 stores in the Miami-Fort Lauderdale-West Palm market.
We also opened a new distribution center in Illinois that will support our store growth there as well as future transportation and operating expenses.
In 2009, we'll utilize our strong financial position to continue to expand in new and existing markets and continue our remodel program in order to grow market share in a difficult environment.
We are planning to open approximately 50 stores with 20 opening in the spring, 30 in the fall.
In addition, we plan to remodel 60 stores in the spring season, an increase from 36 this year.
This allows us to have the flexibility of having real estate became available after the holiday season.
As you know, we have identified over 1400 trade areas where we believe we can open a Kohl's store, but in the current environment, we're uncertain about the time line for future store openings beyond 2009.
We continue to expect that 2008 is going to be a challenging year from a macro economic perspective.
Our second quarter results reflect strong management of inventory levels, and expenses in this environment.
They also reflect the importance of differentiating our merchandise content and marketing, as seen in the impressive growth of our private and exclusive brands.
We remain conservative in our sales expectations for the fall season, and will manage our business accordingly.
We continue to invest in our long-term growth.
We believe it is extremely important to maintain our existing store base in a tough environment with significant competition for customers whose disposable income is shrinking.
We're seeing an improvement in our customer service scores in our stores due to improvements made in the physical environment in all stores, and a focus on engaging our customers on the sales floor and at point of sale.
Our investment in product development, both in talent and technology, continues to provide benefits and increases in both private and exclusive brand penetration and gross margins.
You have seen the results of our investment in technology around inventory management, including assortment planning, cycle-time reduction, markdown and size optimization, and our inventory per store and gross margin results.
We will continue to make investments in our future throughout the year to support our four initiatives, merchandise content, marketing innovation, inventory management, and the in-store experience.
With that, let me share with you our updated guidance for fiscal 2008, and our initial guidance for the third and fourth quarters.
For the third quarter, we would expect total sales to increase 3 to 5%.
Comp store sales of negative 4 to negative 2%, and gross margin up 10 to 20 basis points.
We expect SG&A to increase 9 to 10%.
Wes already gave you guidance on the other lines of the P&L.
This would result in earnings per diluted share of $0.51 to $0.56 for the third quarter.
For the fourth quarter, we would expect total sales to increase 1.5 to 3.5, and comp store sales to decrease between negative 4 and negative 2.
Gross margin increase of 20 to 40 basis points.
We would expect SG&A to increase at 5 to 6% over last year.
This would result in earnings per diluted share of $1.26 to $1.34 for the fourth quarter.
Achieving these objectives would result in earnings per diluted share for fiscal 2008 of $3.02 per share to $3.18 per share.
This guidance does not reflect any additional share repurchases in fiscal 2008.
With that, we would be happy to take some questions.
Operator
(OPERATOR INSTRUCTIONS).
Our first question comes from the line of Adrianne Shapira with Goldman Sachs.
Your line is open.
Adrianne Shapira - Analyst
Thank you.
Pretty impressive on the expense line.
You were able to come in a little bit lower than the 12 to 13% increase you had planned.
We were just wondering in the back half, would you see a similar opportunity?
Wes McDonald - CFO
Well, I think the guys have really done a great job from stepping up from when sales are a little bit lighter than we would think.
So I would expect us to be able to react to that.
But the numbers that we gave you are the numbers that we expect to achieve.
Adrianne Shapira - Analyst
Wes, maybe you can walk through in terms of where you saw that 100 basis point swing, where the buckets were.
Wes McDonald - CFO
The biggest area that contributed were in store payroll.
We were able to flex down pretty well as sales started to soften a little bit in July.
Also, we save a lot of money with inventories being so low.
We don't have to mark it down, we don't have to move it around.
There's not as much replenishment coming in on the seasonal merchandise, and then we also performed a little better than we had planned in our credit business as we continue to gain share.
Adrianne Shapira - Analyst
Great.
And then Larry, you talked about the new stores now -- I guess 70 went to 50.
You have had mentioned opportunities, perhaps as stores become available post holiday.
Does that suggest that you have the opportunity perhaps -- Mervyn's presents an example going back up to 70 if that situation presents itself?
Larry Montgomery - Chairman, CEO
I don't know that we would go back up to 70.
We have flexibility with the 30 that we're talking about in the fall season.
So I think we just judge it as those things happen and do what is best at the time.
But basically we have built in the flexibility to take advantage of the opportunities as we have several times in the past.
Adrianne Shapira - Analyst
Great.
And then lastly, Kevin, just -- you know, pretty impressive gain of the penetration of your exclusive brands.
Give us a sense, what do you think is driving that?
I mean, that is a pretty big step up there.
Kevin Mansell - President
I think it's a the same as it has been probably for the last three or four quarters, Adrianne.
It is the acceptance in the new brands right away.
I think no matter how many times we go back and do the research it all points back to the same thing.
When we identify a brand that we can partner with that already has significant consumer awareness and significant consumer acceptance then the takeoff on that brand is much faster and much more successful.
And secondly, naturally, we're targeting those brands into areas of our assortments where we have voids or gaps.
Put the two of those things together, and I think have had a lot of success.
We see that building.
Adrianne Shapira - Analyst
And maybe just following on that, Kevin give us a sense how you're -- what are you seeing from your customer in terms of, you're talking about emphasizing value as we head in to the back half.
Are you seeing a tradedown within categories?
Opening price points mattering more?
Or still the newness is the more important factor there?
Kevin Mansell - President
I think newness continues to be the most important factor, but there are categories we kind of talked about in the ball, things like basics that have continued to do really well.
In fact maybe even accelerated from a performance perspective, and while we did talk a lot about exclusive national brands, our opening price point private brands also increased in penetration about 100 basis points.
We had a really good success In Apartment9 in both men's and women's and Perfect Pipeline on the male side, young men's and boys.
So opening price point going to be -- continuing to be important.
But I would put most of the focus around newness.
Newness is definitely selling.
Adrianne Shapira - Analyst
Thank you.
Operator
Our next question comes from the line of Chuck Grom with JPMorgan.
Your line is open.
Chuck Grom - Analyst
Thanks, good afternoon.
Wes, on your comp expectation in the third quarter, beyond the trend and comparison from a year ago why you are expecting to see the month-to-month fluctuation?
Are you going to move some credit events around, or could you just elaborate on that?
Wes McDonald - CFO
There's not really any major events shift.
A lot of it is just a function of what the comps were last year.
Last year our worst comp was in October.
Our best comp was in August.
It's mostly a function of that.
Chuck Grom - Analyst
Okay.
And then just on the gross profit front, clearly, you know, 70 bps up in the second quarter, up close to 200 in the second quarter.
The 10 to 20 and 20 to 40 on a one to two-year basis suggest a pretty steep falloff.
Is that just you guys being conservative, or is there less vendor concessions you're expecting to receive in the back half?
Just wondered if you could address that?
Wes McDonald - CFO
I tried to address it, you know, anticipating there was probably going to be some questions about that, given the run rate and margin in the marketing section, which is I think what we have -- what we have come to realize is that we do have a couple of things that are really working in our favor, and we see them continuing to work in the second half of the year, which is our inventory levels have been repositioned.
Our receipts are flowing much closer to sales and it is clearly driving improved margin, and when we combine that with the larger penetration exclusive in the private brands, we do have a built-in margin lift, and we have trying to use that lift to be very aggressive promotionally.
So we're going to try to do that throughout the fall and holiday season, and that is built in to our thinking on this guidance.
So we feel confident about the guidance, but built in to the thinking is that we have got, kind of what we think is a big advantage over some of our competition where both of those things are working for us.
Chuck Grom - Analyst
Great.
Just last question, lean inventory is a clearly a good thing today.
But Kevin, how do you manage the risk in missed sales opportunities that probably presented itself in July over the next few months.
Larry Montgomery - Chairman, CEO
Sure.
I mean it's always a balance, Chuck.
I think it's fair question.
Periods like July, which as you well know are really highly driven by clearance and transitional inventories that are moving out are much more vulnerable to a lower inventory level and a pull back in inventory.
As you move in to more of the meat of the season and its forward receipts, that becomes, obviously a smaller concern, and then secondarily in our case, we made the pullback.
So our inventory was down 15%, and the receipts that were flowing are going to be right in line with the sales we're going to be doing.
So I feel pretty good about that.
But I understand where you're coming from.
We recognize it, and it definitely impacted our July sales.
Chuck Grom - Analyst
Thanks very much.
Operator
Our next question comes from the line of Jeff Klinefelter with Piper Jaffray.
Your line is open.
Jeff Klinefelter - Analyst
Yes, just a couple of questions.
One, Larry to start on the store openings, you made a comment during your prepared remarks about -- something about post 2009, not a specific timetable for new stores although ultimately still seeing 1400 potential locations.
Should we read something in to that in terms of how you are thinking about the sequencing of new stores.
Has something changed in the environment beyond just this near term sales slowdown that changes your outlook.
Larry Montgomery - Chairman, CEO
I don't think anything has changed.
And we have always given a number of stores, about this time of year for the following year, and we think that there's going to be a lot of things going on in the retail community that could afford opportunities that if we don't keep our powder dry, we're not going to be able to take advantage of them.
It's very uncertain times out there, and we are going to run our business conservatively and be able to take advantage of these opportunities.
Jeff Klinefelter - Analyst
Also an update on these Southern markets or these housing-affecting states as some people are calling them.
Maybe, Wes, could you give us some sense within your comp trends how much of a deterioration basis-point-wise those maybe four states are causing you so we can think about what an average run rate is and what a deterioration that -- those states are?
Wes McDonald - CFO
Yes, I don't want to give specifics out, but obviously it's not performing as we would like.
Normally in those younger stores that have been opened two or three or four years, they would be running high single-digit positive comps, and a lot of those cases are running fairly significant negative comps.
It's also affecting our new-store productivity, normally with the blend of stores that we opened between small and protos, this quarter, we would be running at about a 65% productivity, right now we're closer to about a 61%.
That's because approximately 25% of our new and non-comp stores are in those four states I mentioned.
So it's definitely a big head wind and certainly a cause of some of the other retailers that you have seen in the news difficulties that are more -- located in those states than we are.
Jeff Klinefelter - Analyst
Wes, do you have any situations where there are stores that are -- you have to kind of rethink, ultimately, whether or not you would want to keep them open through term?
Do you have any of those situations --
Wes McDonald - CFO
No, I don't think people are going to stop moving to California and Florida and Arizona.
I think that's a long-term trend.
I think we're just in a blip right here and it will work itself out, and developments will continue to grow down there.
What we can't tell you is it going to get better in 2009, or it is going to take a little while longer.
So I'm sure we can get some of your macroeconomic guys to help us out with that.
Jeff Klinefelter - Analyst
Yes, I'm sure they'd be happy to.
One last thing on the credit you mentioned -- I think -- was it 44% of transactions?
Wes McDonald - CFO
Yes, 44.6 for both the quarter and the season?
Jeff Klinefelter - Analyst
And any other details you can give us on credit metrics?
Wes McDonald - CFO
Yes, I would say it was a big help, to Adrian's earlier question in terms of the SG&A coming in a little bit lower than we thought.
Obviously, like everybody else, we're seeing bad debt tick up a little bit to about, we expect it to be up about 100 basis points higher than last year, but both finance charge and late-fee revenue are also up as well, so I expect our yield for the year to be -- flat to last year or perhaps slightly up.
Jeff Klinefelter - Analyst
Okay.
Thanks a lot.
Operator
Our next question comes from the line of Deborah Weinswig with Citi.
Your line is open.
Deborah Weinswig - Analyst
Good afternoon.
Kevin, you discussed some changes -- or at least kind of the thought process with regards to marketing.
Can you talk about if there will be kind of tweaks in the back half or are those more significant changes?
Kevin Mansell - President
I don't know if I would call them tweaks or significant changes.
They -- all we're trying to do, Deb, is recognize the positive impact on our margin from our other initiatives, and balance that against what is clearly a need for more value from all consumers -- they all want more value regardless of which of our price points they are interested in buying, and use that advantage against that need for value, and drive more business.
So we definitely are more focused on it naturally in the back half of the year, because it's such an important part of our business as we get through September to December, you know, it is so critical and as people start thinking about fall apparel and even more importantly, holiday gift-giving, I truly do believe the advantage we have there is pretty significantly competitive, compared to our competition.
So -- it's definitely a positive no matter how I would look at it.
And as I said most importantly, it is definitely built in to the guidance we're giving you on our margin rates.
Deborah Weinswig - Analyst
And then any comments in terms of the strength in the beauty business?
Kevin Mansell - President
Beauty did great.
It comped positively.
I think Wes, roughly low double digits for the quarter, and pretty much the same for the first half of the year, so continues to do very, very well.
Deborah Weinswig - Analyst
And then lastly, with regards to home.
Obvious it's challenging for everyone out there, but it sounds like soft home is even more challenging.
What different initiatives do you have in place from that perspective?
Kevin Mansell - President
We're making changes.
Clearly.
It definitely was significantly worse than the rest of the store and significantly worse than home which underperformed in the store to begin with.
We're looking harder at value in there for sure.
Some of those categories are very basically categories that -- , new bath towel purchases or new sheet purchases or bedding purchases aren't going to be heavily driven by a strong-value offer.
So we're definitely looking at that.
And secondarily we're looking to more aggressively apply some of our brand ideas that have been successful elsewhere to a larger part of the soft home business.
So between the two of those things, I think we have got a couple of good tools, but that is definitely a category that is going to probably be difficult throughout the
Deborah Weinswig - Analyst
Well, thanks so much.
Best of luck.
Kevin Mansell - President
Thanks, thank you.
Operator
Our next question comes from the line of Bob Drbul with Lehman Brothers.
Your line is open.
Bob Drbul - Analyst
Hi, good afternoon.
Kevin Mansell - President
Hey, Bob.
Bob Drbul - Analyst
A question that I have for Kevin is can you maybe address the sourcing environment, as you look in to spring and I guess in the back half of the year, and any sort of challenges that you see there and sort of where things are shaking out maybe by category with inflation and any big surprises from that perspective?
Kevin Mansell - President
I don't -- I mean, from a back-half perspective in terms of impacting our receipts, sourcing is really not going to play a major role.
From the perspective of looking forward in '09, particularly as we turn the quarter in to second quarter purchases of spring of '09.
Price inflation looms on the horizon, and we're obviously working really hard with our overseas partners to mitigate what are a lot of the things that are driving that, whether it be raw material pricing, whether it's natural -- raw materials like cotton or petrochemical-based fibers.
Labor rate, transportation issues, naturally energy issues on the factory base, and they are the things that we have been doing that we still think put us in a good place, which is when we work with the largest overseas agent the world.
And they have an incredibly broad-based flexible sourcing system in place across many, many countries in Asia and central America, and we'll continue to -- while working with the key factories, move production where we can get advantageous pricing to help offset some of those other issues.
It's definitely something we're all going to face come second quarter and back half '09, but I do think we're doing a lot to mitigate the impact.
Bob Drbul - Analyst
And then just a question on back-to-school.
Have there been any major surprises yet for you guys on back-to-school?
And when you think about sort of the first six months of this fiscal year, in terms of like channel competition, off-mall versus mall, or, the discounters versus, you know, better department stores, can you just talk about any surprises that you have seen in terms of the market share gain that's going on out there and, you know, how you see it playing out the rest of the year?
Kevin Mansell - President
I don't think -- I wouldn't characterize anything as a big surprise.
I mean, I think you well know when it comes to younger businesses, those are much more heavily penetrated in mass retail in both children's and even junior's apparel or specialty retail.
So -- and we have tried to attack that with some new opening-price point brands.
Not surprisingly those are working, things like the little size Jumping Bean brand, and new brands in juniors, like Abbey Dawn, definitely working very successfully.
But not -- I haven't -- I can't tell you that there's anything unique going on.
You know, I think it -- it's going to be given the spread of our stores, it's going to be a late back-to-school, because it's later every single year, and I don't think this year is probably going to be any different than that.
Bob Drbul - Analyst
Thank you very much.
Kevin Mansell - President
Yes.
Larry Montgomery - Chairman, CEO
Thanks.
Operator
Our next question comes from the line of Lorraine Maikis with Merrill Lynch.
Your line is open.
Lorraine Maikis - Analyst
Thank you, good afternoon.
Just wanted to touch, again, on the second half sales outlook, which looks like good comps are getting better sequentially.
Can you just talk through the reasons for that?
Wes McDonald - CFO
Well, I think part of it, we looked at our run rate in the first quarter to the second quarter.
We improved.
There's a lot of theories out there about the two-year three-year stocked comp, average comp, all of that.
Sometimes that looks like it plays out.
It's not a dramatic improvement, we just ran a negative 4.6 for the second quarter.
Negative 4 is not too far for that.
We hope that things improve a little bit.
But as Kevin mentioned earlier, our inventories are very lean going in to the quarter and if we're incorrect, I don't think we're going to have any margin rate exposure at all.
Just going to be a question of what the top line is going to be.
Lorraine Maikis - Analyst
Right.
And is there a risk that you got some benefit from the stimulus spending in the second quarter, and that's why you saw the sequential improvement?
Wes McDonald - CFO
I think the real reason was it got hot in June.
Our business is very weather sensitive.
We had poor comps relative to our competition.
In May we had better comps than our competition in June when the weather broke.
And then in July when we had very low levels of seasonal merchandise, we underperformed a little bit as well.
So the weather is as you know -- is very volatile and causes a lot of volatility in our business.
Lorraine Maikis - Analyst
Okay.
Thank you.
Operator
Our next question comes from David Cumberland with Robert W.
Baird.
Your line is open.
David Cumberland - Analyst
Thanks.
Larry you upgraded the store prototype the last couple of years.
Wondering if next year's openings and remodels, are you planning much change to the prototype and also if you can comment on why you are picking up the pace on the remodels?
Larry Montgomery - Chairman, CEO
I think -- we're in our third phase of innovation in our stores, and we test them.
We have a few stores that are going to be innovation this fall, and we're going to take the result of those tests and a roll it out into the new stores for next year, and our remodels.
We think it makes it a more productive store, the customers like it better.
It's easier to shop.
It's easier to maintain, it's lower on energy usage.
All of the above.
So we think we're going to continue to spend money to innovate from a store perspective.
From a remodel perspective, as you know, we have been committed to making sure that we keep our real estate portfolio fresh and competitive.
I think it's a huge mistake not to have that point of view, and I think that as you'll see down the road, it will be a big competitive advantage to us versus the guys that we have been talking about as direct competitors.
Wes McDonald - CFO
Thank you.
Operator
Our next question comes from the line of Dana Telsey with Telsey Advisory Group.
Your line is open.
Dana Telsey - Analyst
Good afternoon, everyone.
You mentioned in your opening remarks about emphasizing customer service.
Is there any change in your approach of how you look at it in this environment versus other economic environments?
Whether it's budgeting for it, or it's just staffing different departments?
Thank you.
Larry Montgomery - Chairman, CEO
We have always had the approach of, you know, we're looking at the in-store environment, and you see all of the new brand launches that we have had.
You see the new strike points, the way we're presenting merchandise.
We think that has a big effect on customer service.
We're showing them how to put those outfits together.
We're showing them out to put those outfits together.
At the same time we're using technology, back of the house, to process freight in a less expensive way, and do a lot of the tasks not related to actually doing business or displaying and selling merchandise.
We have become much more efficient in that.
We're just redeploying -- saving some, but redeploying a lot of those dollars onto the sales floor to make sure the stores are looking sharp, and that, you know, we have got plenty of staff as the people with checking out.
So it's not a big difference in terms of the way that we normally look at it, but as you into through the three stages of innovation we have gone through, we think we're getting a better-looking store, and it's more fun to shop.
Dana Telsey - Analyst
Thank you.
Operator
Our next question comes from the line of Dana Cohen with Banc of America.
Your line is open.
Dana Cohen - Analyst
Hi, guys two questions.
One is on the remodels, you know, is there a material lift to the comp or contribution of those stores or can you give us any sense of the returns, now that you're looking to get more aggressive there?
And then second -- sorry -- if you look at the gross margin delta between Q1 and Q2, penetration of private and exclusive was up similarly.
So is the delta quarter-to-quarter reduced clearance?
Wes McDonald - CFO
Well, I think we did have a lot of reduced clearance, obviously, but we also had good benefit from the penetration in private brands.
We gave some of that benefit from lower clearance back in the form of more aggressive promotional markdowns.
So when you look at it, sort of in detail, we got more of a benefit from the increased penetration of private exclusive brands than we did from reduced markdowns overall.
Dana Cohen - Analyst
And the reason it didn't show up in the first quarter to the same degree?
Kevin Mansell - President
Well, it's Kevin.
I mean -- and I agree with what was said.
The only adjustment to it I would say is we think about the whole thing as kind of inventory management.
It's all about where are we going to put more investment -- and the sales sell through and therefore the leftover inventory and a lot of those exclusive and private brands was much lower as we transitioned out.
So when we talk about clearance, that's kind of one thing, but the sell-through as we transitioned on these was also much better.
The actual absolute merchandise margin, Dana on many of these private and exclusive brands was higher than last year.
So it wasn't just about the mix.
I think you guys are thinking about it strictly from the mix standpoint.
But the absolute margin on the individual brands was also higher.
Larry Montgomery - Chairman, CEO
Dana, it is Larry.
The comment on the remodels is -- we look at it as, number one, a good business practice; and number two, we certainly look at it for the term of the investment.
But we are looking at it from the point of view that if it's not maintained and not kept fresh and competitive, it could have huge deterioration in business.
So we're just sort of heading it off at the pass.
You know, if it's worth being open.
It is worth looking sharp.
And it's worth being competitive.
Dana Cohen - Analyst
Thanks so much.
Larry Montgomery - Chairman, CEO
You bet.
Operator
Our next question comes from the line of Liz Dunn with Thomas Weisel.
Your line is open.
Liz Dunn - Analyst
Good afternoon.
Congrats on managing well in a difficult environment.
I guess my question relates to weather for fall.
I remember last year you were positioned pretty well vis-a-vis the weather with not a lot of inventory and heavy-weight product.
Can you share with us any -- any plans for this fall?
And what is your ability to chase -- chase business to the extent that -- that you are, you know, light in some of those seasonal categories?
Kevin Mansell - President
Well, we have got, it is Kevin, Liz -- we have got flexibility obviously to move up or to move back as you start a season.
You know, the flexibility becomes less than seasonal categories as you get towards the end of the season.
If you need more, you have great difficulty getting it.
But earlier in the season, I think there is plenty of opportunity for us to chase business and flow goods more quickly as it sells.
Naturally we have tried to take in to account last year's experience on some those categories when we planned this year on a by-week basis through the fall, and that's kind of built in to all of our assumptions, but high level it still comes back to focus on cycle-time initiatives, flow our receipts closer to sales, and make adjustments as we see the business happen or not happen.
And I think as we keep focused on that as an organization, you are going to like the results.
Liz Dunn - Analyst
Okay.
Great.
Thanks.
Operator
Our next question comes from Richard Jaffe with Stifel, your line is open.
Richard Jaffe - Analyst
Richard Jaffe here, we say Stifel.
First my compliments guys on a very focused plan, it's working very well.
I guess a sense of inventory is going forward.
Do you have enough, I guess control, so the sales start to accelerate you can build the inventories, or put it another way, are you planning inventories in line with the sales trends we have seen season to date on a per square foot basis?
And is the assortment shifting or consistently shifting to more and more exclusive and private-label brands in the second half?
It certainly appears to be the case.
But just wanted to hear from you guys as well.
Kevin Mansell - President
Well, we're planning -- as we said at the beginning, kind of Richard, I think the one big positive we have is we're starting the season with 15% less inventory.
So our forward receipts don't have to be brought down proportionately.
We can now flow receipts forward as sales happen, and that's how they are planned basically to occur throughout the fall.
As a result -- at the end of the third quarter, we'll be down, and we'll probably be down double-digit.
We probably won't be down 15%.
It will probably be low double-digit kind of decreases.
On a per square foot basis, naturally, our private and exclusive brand, since their penetration has grown so much, they do occupy a larger percent of our total inventory on the floor as well.
But big picture, we think we have a lot of opportunity to improve inventory turnover and -- and really open up working capital for the company, and we're focused on doing that.
So outside of whether we're down negative 2 to 4 as we're projected, or if we do better than that, great.
We still can live with less inventory, because we know we can turn our inventory faster with these inventory management strategies in place.
Richard Jaffe - Analyst
That's helpful.
Just a quick follow-on with Wes, regarding the auction-rate securities, and their ability to become more liquid?
Any changes in the outlook for those?
Wes McDonald - CFO
We sold one for -- for almost $2 million.
We sold it at par.
Obviously, it has been a lot in the news lately.
The various players making agreements.
We're in conversations with brokers that we have used to try to make it more liquid.
We were able to get a line against some of the securities to provide more liquidity, and that's not the solution we want.
Obviously, we want to -- either have people make a market in these again, or refinancing them in to other vehicles so we can be taken out at par.
Having said that, we continue to earn more interest on them than our borrowing costs even though we're not currently into the line.
It's just a complicated situation we continue to work on.
Richard Jaffe - Analyst
Thank you very much.
Operator
Our next question comes from the line of Dan Binder with Jefferies your line is open.
Dan Binder - Analyst
Hi, it's Dan Binder.
A couple of questions.
Is your plan for the back half of the year assume the credit penetration continues at the same pace as the front half of the year?
Wes McDonald - CFO
I don't think it's going to continue at the same absolute delta, because during the back half you get people who don't shop as frequently that use bank cards.
So the penetration sort of drops as we move in to the holiday season.
So it won't -- the delta will not remain -- what did I say -- 250, 270 basis points.
It will decrease from that.
Dan Binder - Analyst
Year-over-year?
Wes McDonald - CFO
Yes.
Dan Binder - Analyst
Okay.
With all of the credit tightening talk, is there any -- are you seeing any limitations in terms of the type of customer you can approve for new accounts?
Wes McDonald - CFO
Well, our approval rates are certainly going down compared to previous years.
Part of that is a function of areas in the country that we're going in to with our expansion program.
Part of that is just obviously with people having more economic difficulties.
Their credit scores are falling across the country.
Dan Binder - Analyst
Okay.
Now you -- are you guiding us towards 307 million shares primarily because you don't expect to do a buyback and keep -- out of drive for store opportunities, acquisition opportunities, or you just don't want us to model it at this point.
Wes McDonald - CFO
We are maddeningly consistent in this point, we never give you guys guidance including share repurchase, so we're just being consistent with our practice.
Okay, I don't know if you addressed this already but is the ad spend as a percentage of sales, do you expect that to continue to deleverage?
Dan Binder - Analyst
Depends --
Wes McDonald - CFO
A function of sales.
Kevin Mansell - President
Yes, I was going to say it actually depends on how well we do on sales, Dan.
Dan Binder - Analyst
Is the ad spend--
Kevin Mansell - President
We're planning it pretty much in line with our sales growth.
Dan Binder - Analyst
Okay.
And then lastly, I know you touched on the remodel strategy, but I'm not sure if you have given us specifics on the cost of the remodels and the sales less you typically see to payback.
Wes McDonald - CFO
The cost have been running around $2.4 million.
I think we'll do a little better than that this year.
You know, the payback is -- you know, we're trying to earn a return over the course of the nine or 10 years to remodel, so we can do it again.
I think the bigger thing which we -- I think Larry and I tried to stress both on the call and other places is we know exactly what happens if you don't remodel.
We have been the beneficiaries of a lot of that real estate.
And we have refurbished it and been successful in that.
And it's not really a sudden acceleration of remodel, it's just a function of our new store growth.
We'll continue to grow remodels to keep the fleet fresh every nine or 10 years.
Dan Binder - Analyst
Thanks.
Operator
Our final question comes from the line of David Glick with Buckingham Research.
Your line is open.
David Glick - Analyst
Good afternoon.
As you look forward to Q4 -- this could be for Kevin or Wes -- how are you thinking about the calendar given the one less week between Thanksgiving and Christmas.
How significant is that and what kind of impact is that going to have on the sales flow?
And how does that change, if any, your approach to marketing and sales promotion during the period?
Wes McDonald - CFO
I can give you the math, and Kevin will give you the strategy.
The math is November is going to be tough, obviously because of Thanksgiving shifts a week later, and December is going to be much better in terms of strategy, Kevin can do more.
Kevin Mansell - President
Without, David without going in to detail that we wouldn't want to competitively.
I have a feeling we will be approaching it similarly to most people which is going to be how do you drive more business earlier, given the later holiday?
And, how do we take advantage of big event marketing earlier in the season pre Thanksgiving in order to offset what is going to be as Wes described it, a tougher month in November, given that the change in the calendar.
Big picture that's how we're looking at it.
David Glick - Analyst
Is the type of calendar that -- I know historically retailers have hated this calendar.
Is this a calendar that is -- has a natural disadvantage going in to it?
Kevin Mansell - President
Nothing has changed of our retailers dislike for that calendar.
David Glick - Analyst
The worst calendar you can have.
But I'm sure you will make the best of it.
All right.
Thanks for the color.
Wes McDonald - CFO
All right.
Thank you.
Operator
We have no more questions at this time.
Wes McDonald - CFO
All right.
Thanks very much.
Larry Montgomery - Chairman, CEO
Thanks.
Operator
This concludes your conference call for today.
You may now disconnect your lines.