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Operator
Ladies and gentlemen, thank you for standing by.
Welcome to Kohl's Q3 2016 earnings release conference call.
Certain statements made on this call including projected financial results are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.
Kohl's intends forward-looking terminology such as believes, expects, may, will, should, anticipate, plans or similar expressions to identify forward-looking statements.
Such statements are subject to certain risks and uncertainties which could cause Kohl's actual results to differ materially from those projected in such forward-looking statements.
Such risks and uncertainties include but are not limited to those that are described in Item 1A in Kohl's most recent 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 replays of this recording will not be updated.
So if you are listening after November 10, 2016 it's possible that the information discussed is no longer current.
(Operator Instructions)
As a reminder, today's conference is being recorded.
I would now like to turn the conference over to our host Mr. Wes McDonald, Chief Financial Officer of Kohl's Department Stores.
Please go ahead, sir.
Wes McDonald - CFO
Thank you, good morning.
With me today is Kevin Mansell, our Chairman, CEO and President.
I will start today's call by walking through our operational results.
Kevin will then provide some more details on our results and our thoughts on the upcoming holiday season.
We will then open up the call to your questions.
Comp sales decreased 1.7% for the quarter, slightly better than the second quarter.
Transactions per store were down 5.7% for the quarter.
Average transaction value increased 400 basis points, comprised of a 210 basis point increase in units per transaction and a 190 basis point increase in average unit retail.
From a line of business perspective men's was the strongest category for the third consecutive quarter.
Footwear also outperformed the Company average.
Children's and accessories were the weakest.
On a regional basis, the West was the strongest region with a low single-digit increase in comp store sales.
The South Central outperformed the Company this quarter, as well.
The Mid-Atlantic and Northeast were the most challenging.
Kevin will provide additional details on sales in his prepared remarks.
Gross margin was up 2 basis points to last year.
Merchandise margin increased 30 basis points but was offset primarily by shipping costs.
SG&A decreased $19 million to $1.1 billion for the quarter and deleveraged by about 12 basis points.
About half the favorability to SG&A is related to timing of expenses and will hit the fourth quarter.
Though our teams did a fantastic job of managing their expenses against their internal plans, most were unable to leverage on the lower sales.
Our credit distribution center and IT teams were able to leverage.
But our store fixed payroll and payroll expenses, corporate and e-commerce fulfillment center expenses did not leverage during the quarter.
Headwinds in the fourth quarter continue to be as expected around store payroll due to wage inflation and continued use of store associates to fill digital demand as well as the timing difference in incentive compensation versus last year.
We continue to believe that our fall season SG&A will be up 50 basis points to 200 basis points higher than last year.
Depreciation expense decreased $4 million to $232 million.
Most of the decrease is due to last quarter's stores closures.
Interest expense decreased $5 million to $76 million for the quarter.
The decrease is primarily to lower interest on cap leases as the portfolio matures as well as the store closures.
Our income tax rate was 35%, approximately 150 basis points lower than last year.
Most of the decrease is due to changes in nontaxable trust income.
Net income on a reported GAAP basis for the quarter was $146 million and diluted earnings per share were $0.83.
During the quarter we reversed $6 million of store closing and restructuring costs that were recorded earlier in the year.
This reversal includes severance for corporate associates that have found re-employment elsewhere as well as lease liabilities for a Milwaukee area store that will be used for corporate purposes.
Excluding the positive effects of store closure and restructuring items this year and $38 million of debt refinance costs last year, net income was $142 million, comparable to the $144 million reported last year.
Adjusted diluted earnings per share increased 7% to $0.80 per share.
We currently operate 1,155 Kohl's stores with gross footage of 99.2 million square feet and selling footage of 82.8 million square feet.
During the quarter we opened six Kohl's stores and closed one store.
All of our new stores are in our new small store format.
We also operate 12 FILA outlets and three Off/Aisle centers.
We ended the quarter with $597 million of cash and cash equivalents, an increase of $96 million over last year, reflecting improved working capital, especially on the inventory side.
Year to date we generated $599 million in free cash flow, an $825 million improvement over the first nine months of last year.
We have made incredible progress on our inventory reduction initiatives during the quarter, reducing inventory per store by more than 9%.
As a result, our AP to inventory ratio increased almost 370 basis points to 44.4%.
Capital expenditures were $591 million, $40 million higher than last year.
Most of the increase is due to spending for our fifth e-commerce fulfillment center which is scheduled to open next year.
Weighted average diluted shares were 177 million for the quarter.
During the quarter we repurchased 4 million shares of our stock.
We ended the quarter with 177 million shares of stock outstanding.
On Wednesday our Board declared a quarterly cash dividend of $0.50 per share.
The dividend is payable on December 21 to shareholders of record on December 7. Our Board also increased the outstanding share repurchase authorization under our existing program to $2 billion.
Based on our year-to-date results and our expectations for the fourth quarter, we are reaffirming our fiscal 2016 diluted earnings per share guidance of $3.12 to $3.32 per share.
Excluding impairment store closing and other costs, we continue to expect diluted earnings per share of $3.80 to $4.
I will now turn it over to Kevin who will provide some additional insights on our results.
Kevin Mansell - Chairman, CEO & President
Thanks, Wes.
We are pleased to see continued, though modest, improvement in our year-to-date comp sales trends for the third quarter in total.
The period included a strong back-to-school selling season with sales up 5% in key back-to-school categories.
But that was followed by a very weak month of September selling period.
I'm happy to say we ended the quarter strongly in October and saw progressive sequential improvement throughout the month as we moved some of our key marketing to better coincide with colder weather.
The month of October ended basically flat last year which is encouraging as we enter the holiday season.
Looking at our sales by business, men's was the strongest business with strength in active and tailored dress clothing.
Footwear outperformed the Company with strength in athletic.
Home was consistent with the Company.
However, home reported the most significant improvement of any business over the spring trend which is a great sign as home becomes much more important in penetration to our overall sales in the upcoming holiday season.
Women's was slightly below the Company but had continued strength in juniors driven by our speed initiative as well as strength in SONOMA and other key proprietary brands.
Children's continues to be challenging.
Strength in Carter's was offset by declines in Jumping Beans and accessory underperformed the Company.
Double-digit increases in bath and beauty and fine jewelry were more than offset by declines in other categories.
Overall, our women's business is beginning to get traction from our speed initiative in several of our key proprietary brands.
I would expect us to grow in impact as we move through the holiday and into the spring season.
The active and wellness category also remains very strong.
We have expanded assortments and introduced newness with key suppliers such as Nike, New Balance and Fitbit and that's continuing to drive sales.
Unseasonable weather as we experienced in September will always be a challenge for us.
It's a reason why localization is increasingly important to our success and we are seeing growing traction in our localization initiative.
We continue to see slightly better sales results: 50 basis points to 100 basis points in localized categories on less inventory versus non-localized categories.
I'm extremely pleased with the freshness and the levels of our inventory.
This is year one of a three-year initiative in inventory reduction and we are managing it well across all areas of our business.
While sales were down 2% for the quarter we ended the period with 9% less inventory and as a result had significantly improved sell-throughs.
Localization is helping as it's flowing receipts closer to need.
This has, in turn, freed up open to buy which has allowed us to invest in stronger trending areas of the business.
It's also provided flexibility to address seasonal differences across the chain.
As a result, about one-third of our fourth-quarter receipts will be spring transitional merchandise, which should help our business in our mild and hot stores and keep our assortments fresh.
I'm also very excited about the exciting new brands that we are introducing.
You already know about next spring's Under Armour launch which will be the largest launch in Kohl's history.
This holiday, though, we are also excited to offer the American Girl Doll of the Year, Koolaburra by Ugg and our most recent announcement the Apple Watch.
These highly recognized brands are sure to drive traffic to our stores and online.
From a marketing perspective we see our positioning on loyalty as the most important differentiator for us in the marketplace.
With the ability to use new technology enablers to personalize our offers and, therefore, grow usage in adoption over time, we believe loyalty has the potential to be a driver of visits and transaction size in a significant way over a long period of time.
On a more near-term basis for holiday, we will be driving hard on all of our loyalty programs including our credit card program, Kohl's Cash and Yes2You rewards program by making changes in execution to heighten and strengthen the effectiveness of the programs and improve our value proposition.
In conclusion, we feel we are very well-positioned for the upcoming holiday season.
We have momentum coming out of October.
We have considerable newness in our stores and online assortments.
Given our much lower inventory position we've created a more appealing selling environment in our stores and we can deliver a substantial amount of new transitional product across the Company as we move through the holiday season.
Whether she shops in one of our stores or online, whether she chooses to have her merchandise delivered or pick it up herself we are committed to providing our customer with a convenient and value-driven experience.
With that we will be happy to take your questions at this time.
Operator
(Operator Instructions) Mark Altschwager, Robert W. Baird.
Mark Altschwager - Analyst
Good morning.
Thanks for taking the question.
First off Wes, congratulations on your impending retirement.
You are going to be missed.
Wes McDonald - CFO
Thanks a lot.
Mark Altschwager - Analyst
I wanted to start off and ask about gross margin.
The rate of improvement pulled back a bit from what we saw in Q2.
Just hoping to get a better sense of some of the puts and takes there.
And then as we look into Q4 and even Q1, comparison is, obviously, quite a bit easier for a merch margin perspective and inventory is down 10%, so I guess the bold case on gross margin could be quite strong.
But what other factors should we be taking into consideration as we model that for the next couple of quarters and any notable pressures we should be thinking about beyond e-commerce?
Wes McDonald - CFO
Yes, we certainly think that we will have opportunity to improve more in the fourth quarter and as you mentioned especially in the first quarter next year.
I think for this particular quarter we, obviously, didn't plan to run down 3% roughly in the spring.
So we did have to take some additional per markdowns in the third quarter, more than we planned to get rid of the spring merchandise.
So that was part of the merchandise margins only being up 33 basis points.
Shipping costs continue to be in that 20 to 30 basis point range on a per-quarter basis due to mix of business and then the actual shipping cost themselves.
As we get into fourth quarter, how well we do on gross margin is really going to be dependent on the mix of business between digital and brick-and-mortar.
If our digital business continues to accelerate in the fourth quarter as it did last year that will put some pressure on shipping cost.
And we might not be able to achieve the gross margin that you guys might expect off of an 80 basis point drop last year.
But I still think we will be able to be in that range of 20 to 40 basis points for the season.
Kevin Mansell - Chairman, CEO & President
And, Mark, the other thing is looking forward the biggest single thing, and I think Wes would agree with this, on our margin opportunity will be our ability to change the process on how we manage receipts.
And that includes both the massive new speed initiative that Michelle is driving as well as localization as a key enabler.
Because both of those things allow us to bring receipts closer to need and they also allow us to bring receipts that are more localized to the individual stores.
So if you look at it on a long-term basis I think those are really the big drivers.
They are more permanent I would say than sort of the temporary things that you are focused on, which is you had poor gross margin last year in quarter four, quarter one last year, therefore you should get big a opportunity.
Yes, we agree, but it's these longer-term things that I think you want to focus on.
Mark Altschwager - Analyst
That's very helpful and thank you.
Maybe more of a macro question if I may, just a lot of noise out there regarding whether the consumer was holding back ahead of the election.
And encouragingly your sales improved in October versus September, which may suggest otherwise.
So just hoping to get your broad views on where the consumer is as we approach the holiday season and whether there's anything you are seeing in your own sales data that would suggest demand has been held back and could potentially accelerate now that we are past the election.
Thanks.
Kevin Mansell - Chairman, CEO & President
I don't think either Wes or I have a good sense of that.
The cyclical nature of our sales in the third quarter, which was really basically really strong back-to-school, really poor September and then very solid October, were probably mostly driven by demand based on weather.
And, yes, I think it's positive that it improved.
But overall I think our experience over a long period of time is things that are distracting like the election, once there is an outcome certainty is a good thing.
So from a positive perspective having certainty on that is probably a good thing looking into the holiday.
Wes McDonald - CFO
Also the fact that weather wasn't very favorable not only affects the selling of cold weather merchandise but we lose the trip to the store, as well.
Mark Altschwager - Analyst
Great.
Best of luck this holiday season.
Operator
Paul Lejuez, Citi.
Paul Lejuez - Analyst
Thanks guys.
First time in a while that you've managed inventory levels down as much as you are.
I'm just curious what has the exercise taught you thus far?
Are you happy what it's done for the business?
I'm curious if there are any places, categories in your assortment when pulling back on inventory maybe constrained your sales to some degree?
Kevin Mansell - Chairman, CEO & President
This is Kevin, Paul, and I can take the first part and I think Wes actually has a perspective on it, as well.
But I think the main thing we are focused on is not making inventory management a point-in-time exercise.
So it's not about pulling our inventories down, we did 9% at a point in time, it's about a permanent change to the way we approach delivering receipts over a long period of time.
So the speed initiative is a key enabler of that because it affects our proprietary brands which is 50% of our business.
Localization is a key enabler because it gets the assortment that needs to be in the right store in the right store.
Those are the more permanent things.
I think everything we are seeing, which is there are plenty of examples in the Company where receipts inventory were pulled way back and sales were actually up, gives us the sample size in the examples to point other areas to say to them, hey, this works as long as it's a permanent process change.
Wes?
Wes McDonald - CFO
Yes I think we are pulling down private and exclusive more than national because that's where the sales are going.
We are also giving up space in private to make room for some of our new brands.
We did have a pretty decent quarter last quarter, Paul, but you are going to win your steak dinner, I know, but that's okay.
But like Kevin said it's a multiyear plan.
I expect us to be down 5% next year and 5% in 2018, too.
So it's a combination of absolutely reducing the receipts.
And then how we flow the merchandise, as Kevin mentioned, that speed initiative is going to be a big factor.
And we are going to look to turn our inventory a lot faster than we have in the last few years.
Paul Lejuez - Analyst
Thanks, good luck and best to you, Wes.
Operator
Lorraine Hutchinson, Bank of America.
Lorraine Hutchinson - Analyst
Thank you, good morning.
Just wondering how much of your assortment is currently on the speed pipeline at this point and where will we see that go over time?
Kevin Mansell - Chairman, CEO & President
Well, it's basically affecting I would say the women's part of our proprietary brands.
So women's penetrate proprietary brands much higher than the 50% for the Company.
And there are, without getting into a lot of detail, I think the way you think about it is it's been launched aggressively in certain areas, juniors for example, and then it is scaling up in other areas, women's sportswear for example, and we would expect that 2017 is the year would have a major impact on the 50% of our business that's proprietary brands.
I don't know if you have got anything to add on that, Wes.
Wes McDonald - CFO
No, I think in general women's I think by the end of the fourth quarter we will have 50% of the business on speed.
And we are seeing a big comp difference between what's on the speed brand and what's not.
Some of the successes I'd say we've gotten a much better comp on the speed brand.
We've been up mid single digits with inventory being down 8%.
So that is a CFO's dream.
So we continue to do that, that's going to enable us to do what we addressed in Paul's question.
Lorraine Hutchinson - Analyst
Great.
And then once you think about the athletic business and prepare for Under Armour, are you thinking about this as just growing your overall active business?
Or do you think it will potentially cannibalize from other brands as you add Under Armour into the assortment?
Kevin Mansell - Chairman, CEO & President
We are definitely thinking this is going to grow our overall active business and that's how we have managed it from both an inventory allocation standpoint, a space allocation on the floor standpoint, a fixture allocation, a marketing allocation.
We just see active and wellness and not just in the traditional sense of active but also the wellness aspects of the business that include technology, things like Apple Watch or a Fitbit but they also include sleep health and eat healthy initiatives.
It's a permanent lifestyle change and we don't see it slowing down.
More specifically to Under Armour I think our expectations are that the active business, footwear and athletic, is going to grow substantially.
And it's not going to pull back the rest of our other actives brands substantially.
It's going to be incremental.
Wes McDonald - CFO
Yes, I expect to get extra trips.
That's the whole key to this thing is to get more people to come to our store for more things and they buy Under Armour and they buy other things, as well.
Lorraine Hutchinson - Analyst
Great, thank you.
Operator
Lindsay Drucker Mann, Goldman Sachs.
Lindsay Drucker Mann - Analyst
Thanks, good morning everyone.
I wanted to ask about the transaction number per store in the third quarter which slowed versus the second quarter, but I was wondering if you attributed that most to weather, whether you saw regional differences in that trend and if the overall trend mirrored the progression of comps across the quarter?
Wes McDonald - CFO
The short answer is yes.
I think weather did affect it, it was different by region.
I think I mentioned that the West region had a positive single-digit comp and we definitely had better transactions as we entered October.
Lindsay Drucker Mann - Analyst
Great.
On the price per unit, the nice sequential improvement there, was curious if there were any specific drivers?
You mentioned you had to take some permanent markdowns given the unplanned weakness in the second quarter, so just was hoping to get a little more detail on that.
Wes McDonald - CFO
Well, the AUR was up about 2%, so the perm certainly didn't help it.
It would have been higher without that.
But I think it's continued strength with our national brands and the content is getting better.
I went back and looked for the Board meeting, it's the first time since 2004 that we have had both AUR and UPT up in the same quarter more than 1%.
So we are getting the customer to pay more for it and they are liking what they paid.
We have just got to get more people into the store, that's the key.
Lindsay Drucker Mann - Analyst
Beyond the merchandise initiatives you talked about, specifically for holiday what are the big focuses for traffic?
Kevin Mansell - Chairman, CEO & President
Both the merchandising initiatives but also the marketing initiatives.
And we sort of alluded to that, that we're really leaning on loyalty in the long term for driving our business.
We are moving more and more of our efforts to our loyalty platforms whether they are the credit card or Kohl's Cash or Yes2You rewards.
But I think some of the reasons why our October moved more positively was that we better effectively landed loyalty offers including the credit card offer, including some Yes2You reward offers into timing where customers are more naturally shopping.
And I think that was a big positive for us.
And I think Michelle has those planned pretty aggressively to do the same thing in the fourth quarter.
Wes McDonald - CFO
I also think that the fact that we talked about men's being better than the Company for three straight quarters and home showing the biggest improvements, both those businesses overindexed in the fourth quarter.
So that gives us some confidence that the sales will continue to improve.
Lindsay Drucker Mann - Analyst
Great, thanks so much.
Operator
Dan Binder, Jefferies.
Dan Binder - Analyst
You mentioned that there was a re-timing of SG&A at Q4.
I'm assuming that's the marketing that you mentioned.
I was just wondering if you could quantify it and tell us a little bit about what type of marketing.
You, obviously, are very promotional already in the fourth quarter, just curious where you plan to spend that money.
Wes McDonald - CFO
Well, I said about half of our favorability or about $8 million or $9 million is going to shift of the fourth quarter.
It wasn't just in marketing, it was in other areas too.
I don't want to really tip our hand on what we are doing from a marketing perspective.
But we are definitely, as Kevin mentioned, focusing on loyalty and focusing on Kohl's Cash.
Those are things that differentiate us versus our competition.
Our Thanksgiving Black Friday event is the only time of the year we do 15% off 50 Kohl's Cash and that's a really big driver to get people into our store versus other stores.
And so we will definitely play that up as we move through the month.
Dan Binder - Analyst
And then I was wondering if you could comment, I may have missed it, if I did I can go back, just the national brand performance versus private label and inclusive.
Wes McDonald - CFO
National brands continue to be positive low single digits and private and exclusive combined were down about mid-single digit.
Private is doing better as things like SONOMA get more back on track.
Dan Binder - Analyst
And the SONOMA relaunch generally I think was well-received.
Is that comping positive yet or no?
Wes McDonald - CFO
Yes, on the women's side, which is the biggest part of the business, it is up mid-single digits in the third quarter.
Dan Binder - Analyst
And then on the last question --
Wes McDonald - CFO
On 19% less inventory.
Dan Binder - Analyst
Got you.
Last question was on the comparisons, you had a choppy fourth quarter last year, as I recall started off really soft, then got strong in the core of the holiday season.
Just curious from a promotional standpoint as you go up against those tougher compares in the heart of the season, should we expect promotions to be heavier or more or less in line with what we saw last year?
Kevin Mansell - Chairman, CEO & President
Again, I think, first of all, as Wes said I don't think we want to get it to the specific activities we have planned in marketing.
But just in general when you think about Kohl's from a marketing perspective, it's natural based on our history that you think a lot about big events, about pricing efforts about couponing.
More and more you're going to see more dependence on product being important to the overall effort and loyalty, which includes our credit card and our Kohl's Cash efforts and our Yes2You rewards effort, to be more and more important.
So that does allow us to time and as I said personalize many of those efforts more effectively.
So it's going to be an intense holiday season.
I don't think there's anything new about that and there's nothing special about that from a year-over-year standpoint.
But I suspect when you look back at the end you will see a noticeable effort to better time our marketing, particularly around how we pull all of our loyalty components together.
Dan Binder - Analyst
Great, thanks.
Operator
Oliver Chen, Cowen and Company.
Oliver Chen - Analyst
Thank you.
When you do look at your month-to-month regarding September, was there anything that could have taken place in terms of trying to reduce that volatility?
And as you do look forward to a lot of these structural positive changes you are making, is your expectation that we could see less volatility hopefully in month-to-month as it relates to weather?
Another topic we were curious about inventory has been a great theme for you.
Previously which inventories were elevated?
It sounded like you had too much and it was harder for the consumer to shop, so I am just trying to understand what edit was critical in terms of doing better with less stuff.
Thanks.
Kevin Mansell - Chairman, CEO & President
I will take the first part of it.
It is Kevin, Oliver.
From a volatility perspective looking backwards to the weak September, there is always things when you look in hindsight that you can say had we done this differently from a marketing standpoint we might have done better overall.
And certainly there were a couple of things, particularly around the Labor Day holiday, that we look back at and say we probably would have done them differently had we known.
But they were informed based on testing and piloting we had done, so I don't second-guess it and I think over time we will continue to make improvements on that.
We are always going to be affected by the seasonality of weather at a point in time.
We just are.
We are heavily penetrated in apparel, we have a customer who shops on a wear now basis for the clothing and accessories.
So we are more vulnerable than some of our competition both negatively but also positively when it's good.
I do think Michelle has made, with her merchandising team, some big changes to lessen the dependence on cold weather as a driver.
And as I said both the localization initiative and speed initiative are key components of that because they put us in a position to better depend upon other classifications within the apparel business to drive our overall business over time.
But we are still going to always be vulnerable as I said both on the negative side and on the positive side on weather.
I do think, though, it's going to lessen and we do see it lessening.
Wes McDonald - CFO
I think we did make a good calendar shift.
With our lowest prices of the season event we moved from August to September where the weather was a little cooler and drove a nice double-digit comp during that event.
So that was a smart move.
Then the other thing I think is we, and you can ask anybody in the Company, I think they know the number, in 2011 and 2015 we grew sales 2%, we grew inventory 29%.
That's not sustainable and we are making progress on doing that and it's a multiyear effort because we want to do it smartly.
Oliver Chen - Analyst
And you may not have an answer for this, but as we think about Trump there's still a lot of unknowns in the marketplace.
Is this something that you think will still be in the minds of your consumer?
I'm just curious about your thoughts from a senior-level as we dissect how this may impact shopping and sentiment and how consumers think about what they may want to spend in such a time of change?
Kevin Mansell - Chairman, CEO & President
Overall I think you can only, as business people we can only manage what we can manage.
So there are plenty of things, though, that we can manage better.
Inventory is a big aspect, but that's driven by receipt flow and I think we are managing it much more effectively than we did in the past and it's giving us a lot more flexibility.
So if, for instance, you feel there's uncertainty due to the continued fall-over from the election I think more flexibility and a business plan is a good thing.
From a marketing standpoint we are trying to do the things that gives us the maximum flexibility, as well, and that is to be less dependent on the big event and be more dependent on tying all of our strong loyalty components together over time.
So I feel like we are doing things with an eye to the long term and that it's benefiting us and it will continue to benefit us regardless of whether or not you think the consumer is in a buying mood for holiday or is still not so much.
And I don't know if you have anything to add, Wes, on that.
Wes McDonald - CFO
I'm not touching that one.
Oliver Chen - Analyst
Thanks for answering that.
I appreciate it and congrats on all the initiatives.
Best regards.
Operator
Paul Trussell, Deutsche Bank.
Paul Trussell - Analyst
Good morning.
Congrats, Wes.
My first question is what will you be doing this time next year?
And then I have a follow-up.
Wes McDonald - CFO
I think I will be on a pontoon -- well, I can still be on a pontoon boat next year.
So we will see.
If the weather never changes in October I could be on one, so we will see.
Paul Trussell - Analyst
Sounds good.
Congrats on that.
Just from a digital standpoint, has e-commerce continued to have the strong gains that you have been posting for the last few years.
Just wondering if there's anything different from recent trends or your set of expectations?
And then also on the door fleet, I know it's a bit early to comment on this but just wanted to inquire on what you have maybe learned these very few short months since you've done the store closings as well as opened the FILA doors.
Kevin Mansell - Chairman, CEO & President
On the digital side I think the trends are similar to what they've been.
People continue to shop and explore and search more online, increasingly, obviously, more with their smart phone than anything else.
We see that in all of our metrics, in all of our trends.
I would say we are seeing increasingly a trend towards customers using that information to transact in our stores, which I think if that were to continue over a long period of time and grow that would be a really good thing for us because as you know one of our key initiatives is to amplify the importance of our store base and we have a substantial store base.
So that would be a great trend if it continued.
But I think overall people continue to use the digital devices that they had to do all the things that make their shopping easier for them.
From a door fleet perspective, I think there are two things that happened in the third quarter, one you are alluding to which was the small number of stores we closed.
It's way too early, I think, for us to draw any conclusions on that.
But I do think by the time we get to February we definitely will owe you and give you some indication of what we are seeing from a holding the trade area sales and other stores and whether or not it was a positive thing or not from a marketshare perspective.
So too early, I wouldn't want to share it, but I promise you that when we get to February we will give you some indication of the impact of that.
The other thing that happened in the third quarter was that we opened up six new small 35,000 square foot stores and the more of those that we open, the more confident we are getting that those are long-term plusses for us, both to get us into trade areas where we can't make the economics of a larger store work, but also just in the long term looking at larger stores that we have that have been more impacted by digital sales and are doing a little less volume than that used to do there's the opportunity for us to scale down the size of the store because we do think that's long term a big positive for us.
You know we've said, and I think Wes agrees, having stores is a critical component of our success.
So I think the small store initiative, and it's early, could be very good for us and certainly the early indications are positive.
Wes McDonald - CFO
And you asked about FILA.
I would say we've had a lot of learnings from that since we opened those in May and we've made some changes for the holiday season and we will be in a better place to tell you more details after the holiday.
Paul Trussell - Analyst
I appreciate the color, guys.
Operator
Neely Tamminga, Piper Jaffray.
Neely Tamminga - Analyst
Great, good morning.
Question here on home for you, Kevin, if you can.
It sounds like home had this nice improvement.
As you alluded Q4 it overindexes, but home is comprised of a lot of different types of trends and categories.
So can you give us a sense of what started to work in Q3 and whether or not that has legs for holiday or some other insights you can give us for holiday?
Kevin Mansell - Chairman, CEO & President
I think Wes can --
Wes McDonald - CFO
I actually know this one, Neely.
Kevin is surprised.
I think bed and bath has been the strongest categories all year and they accelerated in the third quarter.
We also saw some nice improvement in the premium electronics area as we got some of the new versions of things like Fitbit out there.
What continues to be a little softer is the hard home areas and home decor tabletop and cookware.
Neely Tamminga - Analyst
Thanks, Wes.
And you probably won't be on a pontoon if it's up here.
Wes McDonald - CFO
I'm optimistic.
Neely Tamminga - Analyst
All right.
Best wishes to you.
Cheers.
Operator
Brian Tunick, Royal Bank of Canada.
Brian Tunick - Analyst
Thanks.
Good morning guys.
I'm curious about two things.
I guess, one, on Under Armour you guys said being the largest launch in the Company's history, so just curious about the overall brand portfolio.
Are you guys thinking about other national brands or are there specific categories in which you think you are still missing a big national brand or really could be impactful to your customers?
So just curious about that in the same vein of Under Armour.
And then I guess, Wes, when you think about potentially rebuilding to a 37% gross margin over time, can you maybe talk about those positives and negatives including the Buy Online, Pick Up In Store, the digital, things like that offsetting potentially the merchandise margin recapture?
Kevin Mansell - Chairman, CEO & President
I can take the first part and I think Wes can take the other.
On the brand aspect of our strategy I think Michelle would tell you that she is continuing to push hard and explore new additions.
She's had some great success.
We alluded to a couple of the recent, really important ones which include partnership with Apple and the launch of the Apple Watch uniquely as a component of our overall active and wellness initiative which I think is something that will be very positive.
I would say any brands in which we can provide additional help and distribution against the core categories that we think are so important to our business.
So naturally the apparel business is our biggest business and we are looking hard for our expansions in apparel.
And then categories that we really believe in, active and wellness is obviously the most obvious one right now, are ones in which we are exploring more aggressively.
Wes McDonald - CFO
I think we have opportunities in footwear and accessories, but the (inaudible) ones are a little more difficult, I would say.
From a gross margin perspective, very simply we are trying to get back 50 basis points a year of merchandise margin improvement through inventory initiatives.
And I'm especially excited about the speed initiative because that should be incremental to the 50 basis points which should just be able to occur from getting our inventories to the right level.
But that's going to be offset by about 30 basis points of pressure from e-commerce assuming that it continues to grow at the rate that we think it is in that mid-teens range.
So from a modeling perspective if you are looking at a multiyear modeler thinking about how we're going to do 20 basis points a year improvement is probably the best I think that we will be able to accomplish, absent improvement in comps from where we are running today.
If we can improve incomes then that could provide us some margin upside over and above that.
Brian Tunick - Analyst
Super.
Thanks for the color.
Good luck.
Operator
Bob Drbul, Guggenheim Securities.
Bob Drbul - Analyst
Hi, good morning and, Wes, congratulations.
I've got a couple of questions, in the store did you give the Buy Online, Pick Up In Store penetration in the trends that you are seeing this quarter?
Wes McDonald - CFO
Buy Online, Pick Up In Store?
Kevin Mansell - Chairman, CEO & President
The kind of business.
Wes McDonald - CFO
Last quarter it was about 5% or 6% of the digital demand.
We would expect it to go up during holiday.
We are making it more prominent, in the stores we are making it easier, there will be a line that you can go in to pick up your order versus waiting in the general customer service line.
I think we've put a lot more efficient tools in the stores to help our associates pick it in a smaller amount of time.
We are doing a little from marketing perspective to make people realize, especially when they are on the website, that it's available.
I expect that we will get up to that sort of high single-digit range as we get into the fourth quarter.
Bob Drbul - Analyst
And on the capital structure, I think the new buyback program, can you just update us how to think about the trends in buybacks over the next couple of years and share repurchase versus dividend updated thoughts?
Wes McDonald - CFO
Well, we will go through a really detailed discussion with the Board in February on that.
We had a preliminary discussion yesterday, but, obviously, with the increase in authorization we think we can accomplish that over a three-year program roughly.
So that will be about $600 million or so a year for share repurchase, and I would intend to increase the dividend at what level I'm not sure, we've targeted 10%.
I think it would be dependent on what net income payout ratio that we're comfortable with, but I actually think the better metric to look at is the percentage of cash flow.
We've done a really good job this year, and I expect to be able to generate about $1 billion in free cash flow after CapEx expenditures.
So I think we could be able to continue to do a 10%, but whether or not that's the right use for the excess cash we will have that discussion with the Board in February.
Bob Drbul - Analyst
And you talked about some strength continuing in active.
Has the Nike business continued to comp?
Can you give us some updates on how Nike is performing for you?
Kevin Mansell - Chairman, CEO & President
I think Nike was up mid-double digit for the third quarter.
Wes McDonald - CFO
Yes.
Bob Drbul - Analyst
Great.
And then one last question.
You talked about women's, you talked about men's doing well.
In the women's business, Kevin, the cold shoulder style offerings in blouses and tops, there are some offerings on the floor and online and I just wondered if you think that's a trend that can help turn and improve the women's business?
Kevin Mansell - Chairman, CEO & President
Tell you what, Bob, I'll answer that question if you can describe for everybody what a cold shoulder top is.
Bob Drbul - Analyst
So it has -- the shoulders are cut out, and you have some various smocked ones that are there, you have some JLo offerings.
You've got Apt.
9. So I don't know if that's part of the speed initiative, but there's definitely some good trends and styles in those stores, Kevin.
Kevin Mansell - Chairman, CEO & President
Well, you stumbled through that answer, but you did a decent job I would say.
So, yes, it's good Bob.
Thanks for the color for everybody.
Bob Drbul - Analyst
Thanks, Kevin.
Operator
Richard Jaffe, Stifel.
Richard Jaffe - Analyst
Thanks very much.
And, first, my congratulations to Wes as well.
Wish you well and keep in touch.
You can be on all these calls.
We'd love to have you.
Kevin Mansell - Chairman, CEO & President
Let me tell you, no he won't be on these calls.
Richard Jaffe - Analyst
Wes, inventory decline, obviously, is very impressive this quarter and there's more runway ahead.
Do you think this rate of change in your inventory could continue for the next four quarters?
Wes McDonald - CFO
Absolutely.
Yes, absolutely I think.
One of the big initiatives that we are going to do in the fall is some of our lower volume 88,000 square feet stores we are going to fixture like they are a 64,000 square foot store, so that will eliminate the need to just buy product to fill fixtures.
We've done it in over 100 stores already and it's proven to be, not affect any of the sales results and driven pretty nice gross margin improvement to the tune of depending on the vintage it was 25 to about 100 basis points of improvement.
So we have another chunk of about 100 stores that we are going to have in place for back-to-school, and I think that will allow us to continue to reduce inventory without hurting sales very easily.
Richard Jaffe - Analyst
And if you could just comment on the smaller stores, I think early in the presentation you talked about smaller mall stores.
Are you finding that the attached mall opportunity is attractive to you, that that's working with a smaller box?
Kevin Mansell - Chairman, CEO & President
Some of the stores that we just opened in the third quarter actually are what you are describing.
I definitely don't want to get ahead of myself in the 35,000 square foot stores.
We've been open for now I guess six weeks or seven weeks.
But you know that the strategy there had two prongs to it.
One was pretty straightforward which is the gives us new points of distribution in smaller markets where we can't make the economics of a largest store work and makes our ability to reach customers more effective.
You know that we've put a stake in the ground that brick-and-mortar is really important as an omnichannel retailer both to have a place in the customer's mind but also as a point of distribution.
So that's one.
And then the second one is just longer-term aspect which is if you believe the digital sales are going to continue to grow as a percentage of the total then we ought to be able to operate stores in existing areas where we have stores that are simple smaller because they are more efficient.
And it's all positive right now, Richard.
I think we just need more time to give you quality.
Richard Jaffe - Analyst
That make sense.
A final thought on marketing and more traditional advertising in the fourth quarter.
It sounds like that accelerated towards the end of the third quarter and had some positive results.
Could you talk about year over year what advertising will look like in 4Q?
Wes McDonald - CFO
Year over year is going to be up slightly, $4 million or $5 million, not materially.
And it's going to be more shifted into paid search.
As Kevin mentioned earlier, two or three years ago when you did search it drove a lot of traffic to the site.
With the increased use of mobile devices and the ease-of-use that our app and wallet has proven to be effective with our customers, they are using it more to pre-shop.
So we are having to spend more money on paid search to drive people both into the store as well as the website because we are finding that effective use of the marketing dollars.
But so is everybody else, so the cost to do that is getting more expensive.
Richard Jaffe - Analyst
Understood.
Thank you very much.
Operator
Bernard Sosnick, Madison Global.
Bernard Sosnick - Analyst
Good morning.
With regard to children's wear, a price-sensitive category, you've had some difficulty particularly with Jumping Beans.
What are the reasons there, and what does it say about the level of competition that you are facing?
Kevin Mansell - Chairman, CEO & President
I think you know, Bernie, that children's wear is a particularly an acutely competitive category because price is such an important aspect of buying decision.
It's also uniquely different for us in terms of the competitive set where the shares sit.
So unlike let's say women's apparel in children's wear we compete much more aggressively against retailers like Wal-Mart and like Target.
So I think our judgment is that it always comes back to product.
Our prices are great in children's wear, in particular they are great in Jumping Beans.
And you are right Jumping Beans as a brand has been far short of our expectation.
Everything always comes back to product.
And I think Michelle would tell you that that's where we need to put our effort is to give customers better choices in product, to time them from a speed perspective more effectively so they flow more evenly into the store and more localized so they are more appropriate based on where the store is.
I think those are the three big things.
Bernard Sosnick - Analyst
And the other part that was lagging is accessories where if I remember correctly you made a significant effort to improve your offering.
What's happening there?
Kevin Mansell - Chairman, CEO & President
Similar.
I think on the call in the prepared remarks we alluded to the fact that there were a couple of categories actually that performed exceptionally well.
One of them is really encouraging which is fine jewelry.
And as you know the fourth quarter fine jewelry is a more important category, and we haven't had a lot of success in fine jewelry.
The other one has been a more consistent performer for us which is bath and beauty.
That did well and I would expect that to continue.
Our categories that are dragging on sales in accessories are categories like handbags where we haven't had success.
Very similarly to children's wear and the conversation we just had, often these things come back to product and we just have to make better buying decisions and we have to give customers better choices.
So it goes without saying, of course, that that's a high priority for us right now.
Bernard Sosnick - Analyst
Thank you.
I focused on a couple of the weaknesses, but I don't want to leave without saying you are doing an impressive job overall, especially with inventories.
So thank you.
Operator
David Glick, Buckingham Research.
David Glick - Analyst
Thank you, good morning.
And, Wes, best wishes and good luck.
I just want to follow-up on Buy Online, Pick Up In Store.
As you alluded to earlier it was not as efficient, at holiday last year you were just rolling it out.
I'm just curious how big of an opportunity you see that from a sales-driving perspective?
Then secondly, given that it's your most profitable sale, how are you strategizing to build that business?
Are you considering giving customers an incentive, a cash incentive, a Kohl's Cash incentive, for example, to come in and execute in order that way?
Thanks.
Kevin Mansell - Chairman, CEO & President
I think right now to be honest with you we are actually pretty pleased with Buy Online, Pick Up In Store.
To be totally honest, if you just did the calculation for the third quarter Buy Online, Pick Up In Store as a percent of our total digital demand was not as high as we had hoped for.
So we are not trying to dodge that, that's a fact.
But we have been focused on Europe on the fourth quarter because we know that is when the big opportunity presents itself.
And the way we are looking at it, first, is really to have provided best-in-class experience.
And that starts with the enablers on customers' devices, in particular their mobile phone device, to make the experience of buying and picking up in store really, really easy.
And Wes alluded to some of that.
There's all kinds of operational changes that we've made.
I think our sense is that will actually drive the percentage to where we need it to be.
I don't think we need to get at this point at all into more specific incentives for customers to consider to drive them to use Buy Online, Pick Up In Store.
I think if we make the experience phenomenal it is going to be really, really good.
And we seem to be overlooking in some of the questions the positive impact, I think also, of ship from store.
Because again we've put a stake in the ground to say our store portfolio is really important and we believe in it and we are going to amplify it and the way we are going to amplify it is use our stores for all aspects of customer experience which include not just Buy Online, Pick Up In Store but also our ability to ship from store.
So I think both of those for the fourth quarter are going to be phenomenal.
I think we will be talking in February about really good indices on both of those strategies.
Wes McDonald - CFO
I think the key is going to be we have to execute after shipping cutoff because that's the key to get that last trip for the shopper to come into our store.
Because with the 28% I think this quarter attachment rate that helps drive additional sales.
We've just got to get them into the store.
David Glick - Analyst
Thank you very much.
Good luck in the fourth quarter.
Operator
Dana Telsey, Telsey Advisory.
Dana Telsey - Analyst
Good morning everyone and congratulations Wes.
I know this isn't the end.
We will be seeing more of you on these calls or at least hearing from you from time to time.
Wes McDonald - CFO
Thank you.
Dana Telsey - Analyst
As you think about the online at omnichannel effort, what are you seeing in terms of expenses, ability to reach profitability, anything was shipping that we should be mindful of as we are going into 2017 and managing it?
Thank you.
Wes McDonald - CFO
We continue to improve on digital profitability.
So my comments on shipping cost is just it's a fact.
It's not increasing, it's just as a percentage of the business goes forward our cost per package are doing a little bit better.
The key for us is to continue to improve profitability is to reduce the amount of split shipments.
That's the key for probably most retailers.
It's especially important for us given our relatively low average transaction value online which is around $75.
So we have a lot of IT initiatives to do that.
Kevin mentioned ship from store.
That's helped from a speed and capacity perspective.
But we have to continue to help give associates the tools to find all the items in that order so we don't end up having to send a partial order to another store.
That's critical.
So if we can continue to make progress there I think you will see the profitability improve.
Our overall inventories were down about 9% per store.
In e-comm they were flat so that continues and obviously their sales are much better than brick-and-mortar, so we continue to get in turn improvement from that perspective.
So I think we will be able to grow our merchandise margins on the e-comm side, as well.
And the SG&A expenses continue to come down.
The EFC 5 that we are opening next year is going to be three times as productive as our existing EFC.
So we've got a lot of things in the hopper that are going to help us improve that profitability.
Dana Telsey - Analyst
Thank you.
Wes McDonald - CFO
Thanks everybody.
Appreciate it.
I will be available for calls a little bit later.
Thanks.
Operator
Thank you.
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