羅斯百貨 (ROST) 2006 Q2 法說會逐字稿

Good morning.

Welcome to the Ross Stores second quarter 2006 earnings release conference call.

The call will begin with prepared comments by Michael Balmuth, Vice Chairman, President and Chief Executive Officer.

Followed by a question and answer session. [OPERATOR INSTRUCTIONS] At this time, I would like the turn the call over to Michael Balmuth, Vice Chairman, President and Chief Executive Officer.

Sir, you may begin your conference.

Good morning.

Joining me on our call today are Norman Ferber, Chairman of the Board;

Gary Cribb, Executive Vice President and Chief Operations Officer;

Michael O'Sullivan, Executive Vice President and Chief Administrative Officer;

John Call, Senior Vice President and Chief Financial Officer; and Katie Loughnot, Vice President of Investors Relations.

We will begin our call today with review of our second quarter and year-to-date performance, followed by our outlook and guidance for the first quarter and back half of 2006.

We will also discuss our longer range plans and objectives.

Afterwards, we'll be happy to respond to any questions you may have.

Before we begin, I want to note that our comments on this call will contain forward-looking statements regarding expectations about future growth and financial results, and other matters that are based on management's current forecast of aspects of the Company's future business.

These forward-looking statements are subject to risks and uncertainties that could cause our actual results to differ materially from historical results or current expectations.

These risk factors are detailed in today's press release and our fiscal 2005 Form 10-K and fiscal 2006 Form 8-K's and 10-Q's, on file with the SEC.

Today, we reported 2006 second quarter earnings per share of $0.32, compared to $0.29 in the second quarter of 2005.

Net earnings for the second quarter of 2006 were $45.4 million, compared to $42.3 million in the prior year.

Our second quarter 2006 results are inclusive of a $3.3 million or an equivalent of about $0.01 per share in stock option related expenses recognized pursuant to FAS 123R share based payment.

Before these costs, earnings per share for the period grew 14%.

Sales for the second quarter increased 12% to $1.308 billion, with comparable store sales up 4% on top of a 7% increase in the prior year.

For the first six months of the year, earnings per share totaled $0.73, compared to $0.62 in the prior year.

Net earnings for the six month period were $104.6 million, compared to $92.3 million in the prior year.

Results for the first six months of 2006 are also inclusive of a $6.8 million or an equivalent of about $0.03 per share in stock option related expenses, recognized pursuant to FAS 123R share-based payment.

Again, before these option related costs, year to date earnings per share increased 23% compared to the first half of 2005.

Sales for the first six months of 2006 rose 13% to $2.6 billion, benefiting from a solid 5% increase in same-stores sales, on top of a 5% gain in the prior year period.

Year to date, our expansion plans remain on track, with the addition of 30 net new Ross and six dd's DISCOUNTS locations.

We currently operate a total of 770 stores in 27 states.

Second quarter sales and earnings were at the high-end of our initial forecast for the period, benefiting from broad based geographic and merchandise trends.

The strongest region during the period continued to be the southwest, which posted low double-digit percentage gains in same-store sales.

Followed by the Northwest, with high single digit percentage gains.

In California, our largest state, comparable store sales roast 3%.

While Florida trailed the chain.

The best performing merchandise departments were shoes and home.

We also realized better than expected sales gains at dd's DISCOUNTS.

Before the effect of about 25 basis points in stock option related expenses, operating margin was relatively flat to the prior year.

As a percent of sales versus last year, an improvement in second quarter distribution costs was offset by higher strength accruals, freight, store and occupancy expenses.

Merchandise gross margin was up slightly from the prior year but below plan, due to a combination of sharper pricing and a lower than expected improvement in markdowns.

Although down from last year, we believe that in-store inventory was higher than necessary during most of the second quarter.

Better productivity and efficiencies in our distribution and transportation areas have resulted in faster than expected delivery of product to our stores.

This excess inventory that was previously in our supply chain ended up in stores, reducing overall turns and pressuring markdowns.

At the end of July, total consolidated inventories were down approximately 2% from last year, as the growth in the stores was offset by the lower in-store inventory levels.

Pack away was about 38% of total inventories at the end of July, compared to 37% at the same time last year.

We ended the second quarter with an average in-store inventory levels down about 5% from the prior year, which was higher than planned.

Mainly due to a sales shortfall in July when same-store sales rose 1% versus our guidance of up 4% to 5%.

As noted in today's press release, comparable store sales for the first two weeks of August continued to trend below plan at up 2% from last year.

In addition, we are entering the fall season with residual inventory and clearance levels that are expected to pressure gross margin during the third quarter.

As a result, we are adopting a more conservative outlook for the second half of the year.

For the third quarter of 2006, we now are forecasting same-store sales to increase 1% to 3% versus our prior projection of up 3% to 4%.

We reported a strong 9% increase in same-store sales in the third quarter of 2005.

Earnings per share for the third quarter of 2006 now are projected to be in the range of $0.24 to $0.27, compared to our prior guidance of $0.27 to $0.29.

Financial assumptions for our third quarter projection are as follows;

Total sales are expected to grow about 6% to 8% compared to the prior year period.

We are forecasting a net addition of about 29 new Ross locations during the period.

Same-store sales are forecasted to increase 1% to 3% during each month of the third quarter.

This compares to comparable store sales gains of 13%, 9% and 7% respectively in August, September and October of 2005.

Excluding the impact of about 25 basis points in stock option related expenses, operating margin is expected to be in the approximate range of down 10 basis points to up 30 basis points, compared to 4.8% in the third quarter of 2005.

Inclusive of stock option related expenses, operating margin is forecast to be in the range of 4.4% to 4.8%.

A planned improvement in shrink and expenses related to the accounts payable reconciliation that took place in the third quarter of 2005 and ongoing improvement in distribution costs; are forecast to be offset by higher freight, store and occupancy costs as a percent of sales.

For the year, we continue to plan distribution expense to improve about 30 to 40 basis points.

As a reminder, we are getting ready to take a chain-wide full physical inventory in September.

Our current earnings per share forecast assumes no reduction in shrink results from this inventory.

However, we are hopeful that our shortage control initiatives will contribute to some level of improvement.

We are forecasting interest expense of about $500,000.

Our tax rate is expected to remain unchanged at approximately 39%.

And we estimate weighted average diluted shares outstanding of about 142 million.

For the fourth quarter, we now are targeting same-store sales for the 13 weeks ending January 27, 2007, to increase 1% to 3% versus our prior forecast of up 2% to 3%.

We reported a strong 6% gain during the fourth quarter of 2005.

For the 14 weeks ending February 3, 2007, we now are projecting earnings per share to be in the range of $0.57 to $0.63 versus our prior guidance of $0.60 to $0.64.

Included in our forecast is about $80 million in incremental revenue and approximately $0.06 to $0.07 in additional earnings per share from the 53rd week this year.

Our projected earnings per share ranges for both the third and fourth quarters also are inclusive of expenses equivalent to about $0.01 to $0.02 per share per quarter in stock option related expenses.

As a result, for the full 53-week 2006 year, we now project that same-store sales will be in line with our original guidance of up 3% to 4% and earnings per share will be in the range of $1.54 to $1.63, which is inclusive of stock option related expenses equivalent to about $0.06 per share.

As we end the first half of the year, both our balance sheet and cash flows remain strong and healthy.

After paying off the $87 million synthetic lease for the southeast distribution center in early May, and the $50 million term loan for the southwest distribution center equipment in April; we ended the second quarter with $67 million in cash and short-term investments.

We are currently in the process of arranging long-term financing for these capital Investments in our distribution centers.

We also continue to return capital to our stockholders through both our stock repurchase and dividend programs.

During the first six months of 2006, we repurchased 3.6 million shares of common stock for an aggregate of $99 million, as part of the two-year $400 million program authorized by our Board of Directors in the fourth quarter of 2005.

We ended the second quarter with 141.3 million shares of common stock issued and outstanding.

Looking ahead, our focus is threefold.

First, we are working to get our sales back on track by doing a thorough merchandise review of all of our areas of our business to identify opportunities to improve sales trends in the second half.

Second, we are increasing our focus on managing inventories to ensure that we have the appropriate levels in our stores to drive sales while controlling markdowns.

Third, we continue to work on the various initiatives we have in place throughout the Company to improve operating margin over the next few years.

To further reduce distribution center costs, we continue to pursue productivity improvements through engineered standards, partnered with an effective incentive program that rewards our associates for meeting or beating preestablished targets for productivity.

To improve shrink, we are staying focused on our shortage control initiatives, which include a larger number of security personnel and expanded use of the hard security tags and additional digital cameras.

As we said earlier, we are hopeful that these actions will result in an improvement in our overall shortage results when we take inventory in September.

Over the next few years to strengthen our performance in new or underperforming markets, like the southeast and the mid-Atlantic, we will continue to work on designing, testing and gradually implementing new micromerchandising tools.

We believe this initiative will enable us, over time, to get closer to our customers by planning, buying and allocating at a more local level.

To sum up, we generated a solid 23% increase before option increase and earnings per share for the first six months, which was slightly ahead of our original guidance.

In addition, our updated annual earnings per share forecast of $1.54 to $1.63 for 2006 would represent a respectable 13% to 20% growth rate over the $1.36 we reported in 2005.

Nevertheless, we are disappointed that we were unable to realize stronger profits on the better than planned sales momentum in the first half of the year.

Despite our short-term issues, we are confident over the longer term in the resilience of our proven business model and its capacity to generate solid cash flows and returns.

We also remain convinced that over time the strategies and initiatives we reiterated here today will lead to a gradual improvement in our store sales productivity and operating margins.

Enabling us to deliver 15% to 20% annual earnings per share growth over the next several years.

At this point, we would like to open up the call and respond to any questions you may have.

Thank you. [OPERATOR INSTRUCTIONS] Our first question is coming from Jeff Black with Lehman Brothers.

Please go ahead.

Thank you very much.

Good afternoon.

Michael, we've had a lot of head winds on the margin and on sales.

And I would just love to understand, at what point do we step back and say, "we really need to lower operating expenses to drive earnings growth on a lower comp?"

Could you share with us some of the initiatives and tell us is that an important priority?

Because it really was kind of third on your list if I heard it right.

Thanks.

We've been in a several year turnaround of our business.

We're making progress in several initiatives.

Reducing expenses is part of that, whether I repeated it first, second or third doesn't mean it is less important to us.

So, we're going through a thorough review of both expenses and merchandising.

And we understand that we have to make improvement in this area and we're working towards it.

Are there any specific areas you could call out that we're working on?

And secondly, in your 15% to 20% earnings target, what level of comp store sales are you assuming there, thanks?

The specific initiatives that we're working on, transportation is probably one of the key areas that we're focused on.

Not going to go into the details of it but we believe that based on what we see and what we're focused in working on, that we'll be able to realize significant improvements there.

We're also continue to focus in on shortage.

That's one of our biggest challenges that we faced a year ago.

And we've implemented many initiatives today in our stores focused on both internal and external theft.

And as Michael stated in his opening comments, that we are hopeful that when we get our September results that we'll see the improvement that we've anticipated.

And then on the comp guidance?

The 15 to 20, what kind of comp are we assuming you can achieve long-term here?

When we laid out our plan for assuming about a 3% comp.

Okay.

Great.

Thanks.

Good luck, guys.

Thank you.

Our next question is coming from Tim [Geier] with Piper Jaffray.

Please go ahead.

Good morning.

I have just a couple questions for you.

First of all, I was wondering, given recent consolidation within the industry and what seems to be an environment that has seen an increase in both promotional and brand building marketing in the department store and moderate retail channels;

I was wondering if there's anything that you are planning on doing different in terms of reaching out to your customer?

We look at our marketing profile continually.

And as we go through this thorough review in the store, we certainly would be looking -- in addition to merchandising, we will be looking at our marketing initiatives by market.

And being sure that we've positioned ourselves the way we want.

Okay.

What is your marketing spend as a percentage of sales currently?

And then also, what is the breakdown kind of of the media mix within TV, print, advertising, that type of thing?

Sure.

So, overall it runs about 1 point of sales.

And the mix is strongly weighted to TV.

Great.

And then lastly, I was wondering if you could give us an update on kind of the product availability situation, now with the consolidation being at least partially completed?

Yes.

We had no problems purchasing product.

There is plenty of merchandise around.

We've basically had our problems controlling our inventories.

We have had no issue at all.

It seems like a reasonably decent buyer's market.

Thank you very much.

Thank you.

Our next question is coming from Brian Tunick with J.P. Morgan.

Please go ahead.

Thanks.

Two questions.

Michael, trying to understand your comments a couple of weeks ago relative to the sudden slowdown in your business.

Is that any category specifically?

Can you talk about transactions maybe versus ticket?

And then the second question, maybe talk about how your stores are comping relative to maturity, your new stores, entering the comp base versus your older stores.

Thanks very much.

Brian, let me take the first one, which is the transaction data.

So for the quarter, the average retails were roughly flat.

So the comp was driven by an increase in the number of transactions but also in the number of SKU's that the customer -- the basket that the customer left with.

And second part of your question?

How comps looked relative to the mature stores versus the newer stores entering the comp base.

And then you didn't really answer my question.

It was last week or two weeks ago, comments that you saw a sudden slowdown in your business.

So, we're just trying to understand what happened in July to your business, do you think?

July business, it slowed down in a very broad-based manner, both departmentally and geographically.

So, when that happens at a transitional time in the year, you have to take a breath and watch it a little and get through the back-to-school period and understand fully.

Whether it is a late back for school or whatever it is, we are assessing it and tearing it apart right now.

On your other question, the new markets are comping comparable to the chain.

If that's what you were getting at.

Okay.

Thanks.

Thank you.

Our next question is coming from Kimberly Greenberger with Citigroup.

Please go ahead.

Great.

Thanks.

Good morning.

Michael, I know you said you're assessing the slowdown in your sales.

Any initial gut feeling that you have on that?

And secondarily, how long do you expect to take in order to resolve the inventory overage that you talked about?

And then in light of the earnings shortfall in the second half of the year, how are you thinking about bonuses?

Thanks.

Okay.

I think it is too early to for me.

I have to get through back-to-school before I would have a strong point of view on what transpired in July.

And could you tell me the second one again, please?

I am sorry.

You indicated that the inventory in stores is running -- continues to run above your plan.

When do you expect to have that in line?

Well, I think by the end of August, okay?

We were -5 coming out of July, and see ourselves moving into where we want to be coming out of August and running it that way through the rest of the season.

Okay.

And then thoughts about how you're thinking about bonuses here in the second half?

And is there an opportunity maybe to reverse the prior quarter accruals?

So, if we look at the year, Kimberly, we're basically within the guidance we started with for the year, I won't see reversing the bonus going out.

Okay.

Thanks.

Thank you.

Our next question is coming from Marni Shapiro with [Reid, Charles, Sacher].

Please go ahead.

Can you talk a little bit about the regions where the newer stores were struggling for Ross Stores stores, if you've seen any improvements there and any changes you've made?

If you could also talk specifically about apparel.

What is working well and where do you see the weakness as you've come into August even?

The newer regions are comping with the trend -- with the chain.

Okay?

That was your first part of it Marni?

Can you repeat the first part of your question, Marni?

The regions where you were seeing softness last year, the newer regions, you were going back to assess them before you grew them aggressively.

How is the business in those areas today?

As I was saying, it is comping with the chain.

We still have a lot of work to do to get it ahead.

There is catch-up there but it is improving somewhat.

Okay.

Thank you.

Our next question is coming from Mark Montagna with C.L. King.

Please go ahead.

Just a question about dd's.

You had mentioned that sales were up and above plan.

But I'm wondering, how are you doing in terms of operational improvement with dd's?

Is it improving to the point where it is hitting your objectives?

We're seeing some improvement.

We've been working diligently at it and we're looking at our expansion program for next year.

So, does that mean that you're on target with where you're trying to get?

Are you behind?

Pretty much, pretty much.

All right.

So, would that mean that we could perhaps expect a greater expansion rate next year or still slow?

We probably wrap that up at the end of the year and talk more about it but we're feeling pretty good about the comps.

All right.

Thank you.

Thank you.

Our next question is coming from Ben Strom with DE Research.

Please go ahead.

Could you just dive in a little bit to the residual inventory, just maybe by category, where you're really having a build-up and where some of the issues are if possible, like women's bottoms, denim, et cetera?

When we looked at that, it is pretty broad based in terms of the over inventory that we saw.

I wouldn't call it any one specific category.

Okay.

As Michael said, working to get that back in line, and we're on plan to do that.

Okay.

So, nothing stands out?

No.

Okay.

Thank you.

Thank you.

Our next question is coming from David Mann with Johnson Rice.

Please go ahead.

Yes.

In terms of your comments on shrink, have you been able to do any cycle counts, which have given you any confidence your shrink accrual may may be too high?

Relative to cycle counts, we really don't do any cycle counts per se.

And we have been testing the initiatives that we have in place, which leads us to be hopeful that come September we'll show improvement.

And relative to the accrual piece, John, --

Hand-in-hand with what Gary said.

We have some indication that we should be hopeful but again, we'll know when we know in the third quarter.

And any improvement in shrink is not in your guidance, right?

That is correct.

Okay.

Thank you.

Thank you.

Our next question is coming from Margaret Mager with Goldman Sachs.

It is Margaret Mager at Goldman Sachs.

Can you talk about specifically the new store productivity?

Is this a material drag on the business at this juncture?

What is the thought about the appropriate level of square footage expansion, not just near term but longer term?

And I have one more follow-up to this.

Okay.

I think we've said in the past that there are a number of new stores, certainly not all, but a number of new stores in the region of 56 that we've opened in the past few years; that are performing at levels lower than we would have expected.

We're doing sort of two sets of things to address that.

There is short-term things we're doing.

And they include looking at what products are selling well in those stores and what products aren't.

And then obviously investing more in those products that are, those merchandise categories that are.

We're also looking at new stores in terms of stores that we're opening and how we inventory those stores in terms of assortment.

There are a number of short-term things we're doing and we believe that those will help.

But we also think there is long-term steps that we need to make to make those improvements sustainable.

And when Michael mentioned merchandising earlier, that's kind of the project name that we've given to those longer term activities.

So realistically, those longer term steps are -- they're going to take a couple of years to come to fruition.

So, that's the approach that we're taking with those new market stores.

So to my question, is it a material drag or is sort of the disappointments across the whole chain or is the new stores really a stand out negative at this point?

And then how does this translate into how you think about expansion longer term?

On the expansion piece, I think we said on an earlier call that until we figure this out, we're going to sort of continue to expand within our existing markets.

We fundamentally believe we succeed within all the markets that we're in today.

And that's where we're focusing over the next couple of years.

As we sort of improve our ability to merchandise new stores and new markets, we'll start to expand into other new markets, perhaps.

I think we said that would be 2008 at the earliest.

Okay.

Margaret, this is John.

So what's going on with the new stores, what it causes us to do is our average store volumes remained relatively flat and maybe up 1 point or so.

And so that puts pressure on the expense lines when you have cost faster than the average store volumes and we're working to address that issue.

At some point, as a management team, do you take a step back and say; " You know what?

It has been a number of years now of disappointments for a variety of reasons."

And you can point to systems, inventory management, sales, a variety of things over a number of years.

At some point do you step back and say, "something has changed secularly and we have to rethink things in a much bigger way."

For example, gross margins just cannot go back to 25%.

So, at what point do you sort of start to change your thinking in a much bigger way than just; let's try these tactical things to try to improve our current situation?

Margaret, the truth is we do that all the time.

So, we're always scanning the environment.

We're always looking at our own performance.

We're always looking at peer retailers performance to understand strategically;

Has anything changed?

And we do that in a reasonably rigorous way.

And from a customer point of view;

Has anything changed?

Having looked at all those things, customer, competitor, supply issues, we don't believe anything has fundamentally changed in our business.

Our model continues to be, we think, a successful model.

Now, have things sort of gone wrong in the last couple of years?

Absolutely, and we've spoken about those.

And the steps that we've taken are intended to address those.

But do we think that strategically something has fundamentally changed?

We don't.

Okay.

Well, I appreciate your thoughts.

Take care.

Thank you.

Our next question is coming from Rob Wilson with Tiberon Research Group.

Please go ahead.

Speaking of change, has anything changed in how you're spending your TV advertising dollars over the last year or potentially going forward?

Over the last year nothing has changed, and as we said before, we're looking at how we're handling our marketing now.

And so something could change going forward but we're not prepared to talk about it.

Has there been a thought of direct mail?

No.

Okay.

And finally, I am kind of new to your story.

So I look at your inventory levels, and I look at the numbers, and I say; "wow, they're well controlled the last six or seven quarters."

Can you help me understand why you think inventory levels are a problem?

Yes.

We believe that we have residual markdowns related to a lack of turn, which relates to too much inventory in the stores, Rob.

So, I think that we think we can tweak that, bring that down, and make sure we get the profitability on the sales.

That was one of the drags that we were disappointed about during the first half, was not being able to convert.

Rob, by having a material difference in how fast we're moving product through our stores, we have -- we can see statistically we can live with less.

And that's really what we've been talking about.

And by the fact that we didn't live with less earlier, we've put too much product in front of customer, even though it might appear to you that we are controlling it well.

And in our minds, we've we had a material year-over-year inventory level difference because of speed.

That helps.

Thank you.

Thank you. [OPERATOR INSTRUCTIONS] Next question is coming from Kim Gail with Pioneers.

Please go ahead.

This question is for Norman.

Norman, I am wondering if you could please comment on the Board's view of the Company's performance over the past three years?

And maybe what you think is an appropriate time frame for correcting the issues that have developed over that period?

I think as the Board looked at the difficulties that we accomplished in 2004, we knew that 2005 and 2006 would be decent years and we knew there would be some residual issues.

I think we've seen some residual issues.

I think everyone is working diligently to correct them.

And the Board basically has confidence that this Company can come back, as it has come back in the past. and we can show sustainable 15% to 20% earnings per share growth going forward.

So, I would say the Board is confident in the model and confident in the management team.

The Board also doesn't seem to have retail experience outside of Ross, certainly not of any great depth.

Have you considered expanding the size of the Board to add some folks with greater depth of retail experience?

Well, we do have people in the Board who have had a lot of retail experience such as Stuart Moldaw and Michael Bush, just to add two, including myself.

But we are always looking at potentially expanding the Board and something that the Board consistently looks at.

But at this point I don't think that there is a jugular issue, at this point, for this Company.

We've got this short-term issues, we've got some long-term challenges and opportunities.

And those are what we're really focused on.

Because it just seems that the core business that Ross is in is a very good business and it seems surprising to have underperformed for so long.

Well, I would say that a lot of the underperformance so long has to do with some errors that we made in systems and DC expenditures in 2004 that we have been paying for.

Although we've shown some increase on an earnings per share basis, reasonably, over the last couple of years.

Our operating margin obviously has shrunk somewhat.

And primarily, the areas that it shrunk in is in margin and distribution center expenses and shrinkage.

So, those are very heavy areas.

And we believe that just in those areas right off the bat is tremendous opportunity to get back to very close to where we were.

So I think over time I think we'll be fine.

Great.

Thank you.

Thank you.

Our next question is coming from Michael Hidalgo with [Tiedro] Capital.

Would you please discuss California, particularly in light of the some of the strange and hot weather they've had there and just remind us what percentage of your overall business that is?

Can you please repeat that question?

You didn't come through clearly there, Michael.

California, would you please discuss how the business has been performing in light of the hot weather that has been there and remind us how much of your business California accounts for?

Yes.

For the second quarter California comped at 3 comp, which compares with the chain of 4%, so slightly below the chain.

And then in terms of the size of the -- it is about 30% of the chain between northern and southern California.

Okay.

But was there any -- did you see any sort of dramatic effect?

I was out there several weeks ago, and it was very hot relative to historical --?

Like we said, we saw decline in sales trend in July.

We're not meteorologists.

We don't know to what degree to assign that sales trend to the weather or to other issues.

So, our starting point is make sure our assortments are right and then if the weather turns, we'll be in even better shape.

All right.

Thank you.

Thank you.

Our next question is coming from Dana Telsey with Telsey Advisory Group.

Please go ahead.

Good morning, everyone.

As we think about the changes that you're undergoing and the merchandising changes and the benefits from the system, how do you look -- in terms of the timing, why does it take so long to implement and reap some of the benefits?

Is there a timeline or schedule that we should look for, like step one this is in place, step two, that's in place, so we're able to gauge, too, to see that it is on track?

Thank you.

I think from a merchandising end, if I am thinking, Dana, that you're talking about the system changes we've gone through, they're not inhibiting our business at all.

Okay?

So, you could take your timeline to the end and say it is fine.

Now, micromerchandising will take us a few years, and we're developing our full timeline on that.

And when we get further along, we'll share it but I hope that answers.

Let me elaborate just a little bit.

Because I think if we were back in 2004 and you were asking that question, we would have said the number one priority is to stabilize the systems and get them to provide the information the business needs.

That's done.

So, we're through that.

We're kind of in a mode now of sort of getting the system to do some extra things that we've never gotten to do before and that's helping us.

And the next phase, I think, over the next few years is to get it to support things like micromerchandising, which again, are more sophisticated but we believe will help our business significantly.

So, that's how I'd characterize the evolution of sort of how we're thinking about the systems.

Thank you.

Thank you.

Our next question is coming from Kimberly Greenberger with Citigroup.

Please go ahead.

Thanks.

John, I was hoping you could detail for us the basis point movements in DC shrink, freight, et cetera, and gross margin and also do the same in SG&A?

Sure.

And then, Michael, if I could just ask you one follow-up.

August.

How does the 2% month to date comp compare relative to your original expectations, and you have any thoughts there?

Thanks.

Kimberly, I will walk you through leverage points.

Merchandise margin was up about 20 basis points before shrink and freight.

You take those shrink and freight together, total gross margin was down about 20, offset by improvements in DC's of about 40 basis points.

We had in the gross margin line around 10 basis points of options expense.

Related to the store or the expense leverage, as I said before, average store volumes are putting pressure and headwinds on store operating costs.

They were up.

We had another 15 basis points in options expense on that line item as well.

So, that will give you some perspective.

And relative to our sales trend, the 2% relates to -- it was approximately 2% to 3% below what our expectations were for the month.

We're only halfway through it, so we'll see how back-to-school performs the rest of the way.

Okay.

And then, John, on occupancy, I am just trying to understand how with the 4% comp increase how you could be deleveraging on the occupancy line?

A couple of things going on.

There was a slight change of accounting where now we have to expense the preopening piece of the rent, that's putting some pressure on it.

We have newer stores coming into the model with higher rent that are putting some pressure on it as well.

And it has been a pretty consistent theme over the past couple of quarters and probably will continue through the rest of the year relative to the deleverage on that line item.

Thank you.

Thank you.

Our next question is coming from Frank Alonzo with Price.

Go ahead.

Hi, guys.

Just real quick, can you kind of elaborate a little bit on, you mentioned exploring longer term financing for distribution centers, some of the other assets?

Why do you do that?

Do you want to free up cash to accelerate share repurchase?

And I'm just kind of curious because it doesn't seem like you need the capital unless you would be looking to buy back more stock, which certainly makes sense, as the stock has kind of languished here for a few years.

Frank, let me describe what we're doing and then tell why you we're doing it.

We're looking in the process of arranging some long-term financing, looking for about $150 million in senior debt.

We have commitments around that.

We will finalize a definitive agreement in the third quarter and draw that down in the fourth quarter.

Our view is taking longer term financing on bricks and mortar makes sense from a shelter perspective, it makes sense from a leverage perspective.

Obviously, we're not that leveraged but we think a bit of leverage is probably smart.

Relative to our buyback, our philosophy has always been to deliver excess cash we generate back to shareholders in terms of a buyback, and I don't think we'll deviate from that.

So, there is no chance you would accelerate beyond the pace at which you're doing, despite the return you would get by kind of buying back the beast you know, if you will?

We don't tend to be market timers.

Occasionally when there has been a huge dislocation we've just step up but we just constantly look at that stuff.

Okay.

Thanks.

Thank you.

Our next question is coming from Mark Montagna with C.L. King.

Please go ahead.

You had mentioned earlier that you expect to grow earnings 15% to 20% on a 3% comp.

Now you just mentioned about deleveraging on a 4% comp, and that I thought you said that that trend would continue.

So, I am trying to reconcile those different statements and how you can I think you said get a 3% comp with and grow EPS 15% to 20%?

So, the statement related to occupancy deleverage specifically, we have other offsets throughout the P&L that would give us the operating margin improvement.

Clearly, the disappointment was in the merchandise margin line.

We should have had greater follow through on the over plan sales, and that's where we were disappointed.

Having said that, earnings per share was up -- option expense was up 23% in the first half.

So within kind of where we thought it would be and the year, as we look throughout the year lowering our guidance, giving us a little bit more room and being more conservative.

Still think that we'll be within the original guidance that we first set out in the beginning of the year.

Okay.

So, just to confirm, to grow at 15% to 20%, you do think all you need is a 3% comp?

Yes, over the longer term we feel that's the case as the shrink initiatives kick in, the DC initiatives kick in, we need to make improvements there.

All right.

Thanks.

[OPERATOR INSTRUCTIONS] Our next question is coming from Ken Gail with Pioneers.

Please go ahead.

Just a follow-up.

If your top line is growing based on current square footage growth rate in comps, somewhere between 8% and 11% and your margins are 300 basis points below the peak, why is it acceptable to only grow EPS by around 15%?

So, the statement was 15 to 20, Kim.

Well, Why is that an acceptable number?

We think that that level and growing in -- we believe that's a controllable level.

We believe that gives us the return that we need.

And we think to exceed that level would take -- obviously, we'd comp better if we'll exceed that level.

We think 3% is probably appropriate.

And to -- the other way you drive that is adding more stores and at this point in time, we don't think that's a prudent move.

It just seems that that implies a pretty gradual level of margin recovery.

That's what we've said, over a period of time.

It's going to take several years to get it back.

And there is no sense of urgency that it should get back sooner?

There is a huge sense of urgency.

I think we plan on 30 to 50 basis points improvement per year.

And we don't take that lightly.

We feel that there is a very strong sense of urgency around that.

If you can do 30 to 50 basis points a year, then really your EPS should grow a lot faster.

Ken, we can walk through that specifically.

Stores grow.

Added comp to that to a 3, total sales are growing kind of 9 to 11.

Operating margin continues to expand 30 to 50 basis points.

You get earnings of between 14% and 18%.

You do a buyback that adds 1% to 2%.

The gets you to 15% to 20% from an operating standpoint.

I think I would beg to differ on the math but anyway thank you.

Thank you.

There appears to be no further questions at this time.

I will turn the floor back over to you for any further closing remarks.

Thank you all for attending.

Have a good day.

Thank you.

That does conclude today's teleconference.

You may disconnect your lines at this time and have a wonderful day.