Urban Outfitters Inc (URBN) 2006 Q3 法說會逐字稿

Good day and welcome to today's teleconference. [OPERATOR INSTRUCTIONS] The following discussions may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Please note that actual financial results of the Company for the periods being discussed may differ materially from the financial results projected or implied in the forward-looking statements.

Additional information concerning factors that could cause actual financial results to differ materially from projected results is contained in the Company's annual report on Form 10K and in other documents filed by the Company with the Securities and Exchange Commission.

The Company disclaims any intent or obligation to update forward-looking statements.

No recording or rebroadcast of this call is permitted without the Company's express written permission.

I would now like to turn the call over to Mr. Richard Hayne.

Go ahead, sir.

Good morning, everyone, I'm Dick Hayne, Chairman of the Company.

Welcome to the Urban Outfitters quarterly conference call.

Today we will review our third quarter financial and operating results.

I will read a prepared statement reviewing those results and then our executive team will assist me in answering your questions.

The team assembled with me this morning includes John Kyees, Chief Financial Officer;

Glen Senk, Executive Vice President and President of the Anthropologie brand;

Freeman Zausner, our Chief Administrative Officer;

Glen Bodzy, General Counsel;

Bob Ross, Controller;

Calvin Hollinger, Chief Information Officer; and Chris DeWitt, Managing Director of the Free People Brand.

Ted Marlow, our President of Urban Outfitters brand who usually joins us as well, is out for several days due to a death in the family.

Earlier this morning, we issued a press release outlining our results for the quarter and nine months ended October 31, 2005.

You can access that release at the Company's corporate Website.

The address is www.urbanoutfittersinc.com.

Remember, if you're trying to access that, it's urbanoutfittersinc.

It's all one word with no punctuation or hyphens.

In addition, a transcript of today's prepared statement will be posted on the Site later this afternoon.

This year's third quarter was the best quarter in the Company's history.

That’s by many measures; the revenues generated, the operating profitability as a percent of revenues, the net profits created, the number of stores in operation, the number of direct orders shipped and the amount of wholesale products sold.

In addition at the end of the third quarter, the Company had more cash and marketable securities on hand and higher shareholders' equity than at any other quarter in the Company's history.

A review of our third quarter highlights this year versus the same period last year shows that net sales topped $288 million, up by more than 33%.

Total comparable store sales rose by 13%.

Direct to consumer sales advanced by 32%.

Wholesale sales jumped by 109%.

SG&A expenses leveraged by 168 basis points.

Total operating margins set a new quarterly record at 21% of net revenues.

Earnings per diluted share on a split adjusted basis shot up by more than 40% from $0.15 to $0.22.

Shareholders' equity increased by more than $145 million or up 39%.

And the Company opened 11 new stores during the period, four Urban Outfitters, five Anthropologie and two Free People stores.

These outstanding results once again confirm the validity of our strategy to create and promote multi-channel brands that connect with the customer on an emotional level.

They also demonstrate the ability of our teams to execute this strategy.

I have broken the results into five segments, sales, operating profits, inventory, earnings and shareholders' equity and will review them in more detail.

First, a look at the sales.

In third quarter, the Company produced record sales of $288 million.

This is a 33% increase over the same period last year.

Four factors drove this increase.

The biggest being the sales generated by new stores.

There were 36 new stores in operation at the end of the period on a base of 126 comp stores in operation at the beginning of last year's third quarter.

This year, new and non-comp stores added about $31.7 million to total revenues during the quarter and accounted for 45% of our total revenue increase.

From the beginning of the current fiscal year through the date of this release, the Company has opened 21 new stores, nine Urban Outfitters, nine Anthropologie and three Free People stores.

A number of new stores that opened during the quarter produced superior sales results including the Urban stores at the Somerset mall in Troy Michigan and The Tysons Corner mall in McLean Virginia.

The new Anthropologie store in Carlsbad, California set the single day opening sales record for all of our brands.

And the new Free People store in Tysons Corner mall had the best single day opening sales for that brand.

In addition to the 21 new stores already opened this year, we plan to open at least nine additional new stores in the remaining 2.5 months of the current fiscal year.

A 13% increase in comparable store sales was the second largest factor.

It accounted for 32% of total revenue gain.

This comp store sales increase follows an 18% advance in the same period last year.

By brand, comps rose 19%, 7% and 21% at Urban Outfitters, Anthropologie and Free People respectively.

Comp store sales were driven by the apparel and accessory product areas in the Urban Free People stores, while the home product area performed best for the Anthropologie stores.

The total average unit retail selling price increased by almost 9%.

Units per transaction were flat, and the total number of transactions climbed by 4%.

The third factor was the 109% surge in Free People wholesale sales, which accounted for 13% of total revenue gain.

This exceptional performance was primarily due to an increase in large department store orders, which drove an 89% overall lift in average order size.

Also helping to fuel the gain was a 14% rise in the average unit wholesale selling price.

During the period, Free People opened its hard first shop within Bloomingdale's at their 59th and Lexington Street store in New York City.

Sales in that shop have been extraordinarily productive.

The wholesale group has added one new product delivery for the period ending in November called appropriately, The Gift Delivery.

We expect Gift Delivery will help drive fourth quarter wholesale business.

Finally, the last factor, direct to consumer sales for the period rose 32%.

It accounted for 10% of the total revenue increase.

Total catalog circulation increased by 12%, while the average order size rose 15%.

Total unique visits to the Company's three Websites jumped by 38%.

The Free People brand mailed a second test book in August and will launch its full direct response catalog this November.

The Urban brand will increase the distribution of its gift book later in November by 40%.

And Anthropologie plans an 11% increase in fourth quarter catalog distribution.

Now let's look at the operating margins.

As in past quarters over the last few years, we concentrated on growing operating margins while increasing sales.

And once again we had significant success in both areas.

While sales were increasing by 33%, third quarter operating margins as a percent of net sales climbed over 100 basis points to 21%, the highest operating margins in the Company's history.

About half of that increase was a result of one-time gain from the sale of an office building.

Even without that gain margins would have set a new record.

Meanwhile, other factors driving margins higher included; tight control and therefore significant leverage in the store controllable expenses.

This is mainly in the area of store payrolls.

Significant leverage of administrative expenses.

Tight control over merchandising and selling expenses.

Improved efficiency in the direct to consumer order handling management, as a result of the new South Carolina call center and fulfillment center facility.

And slight leverage in the area of store occupancy expenses, as the impact of the new interpretation of lease accounting rules mostly offset the positive effects of higher than planned comp store sales.

Somewhat offsetting these improvements were; additional markdowns to maintain fresh inventories.

Additional freight expenses from fuel surcharges and the cost of merchandise.

And new technology investments to implement many of the previously announced shared service initiatives.

At the end of the period, total inventories grew on a year-over-year basis by $57.3 million.

The majority of this increase was required to stock new stores.

On a comparable store basis, inventories increased by 22% on a dollar basis and by 18% on a unit basis.

During the quarter, we successfully utilized aggressive markdowns to plan the inventories and achieve acceptable weeks of supply on hand.

We also accelerated the delivery of our holiday season merchandise by several weeks.

Our sales trend to date in November continues to significantly exceed our plans of low single digit comp store sales gains.

Thus, we believe that current inventory levels are proper to support that trend as we head into the holiday selling season.

We do, however, expect to slightly reduce the weeks of supply by the end of the fourth quarter.

As for net income, it's our goal to have profits for the quarter grow significantly faster than sales.

Net income jumped by 43% over profits earned during the comparable quarter last year.

Third quarter earnings per diluted share increased from $0.15 last year to $0.22 this year.

All channels of distribution were solidly profitable and all three brands posted double digit, after-tax levels of profitability.

Finally by the end of the third quarter, shareholders equity had increased by 39% over the same time last year.

With this $145 million increase in shareholders equity, we topped a $0.5 billion for the first time in the Company's history.

So to summarize our major achievements in the third quarter, our Company grew total sales by 33% to $288 million.

Drove total comp store sales by 13%.

Continued to deliver solid store level productivity gains.

Achieved quarterly operating margin of 21% of net sales, the highest operating profit in the Company's history.

Grew our earnings from $0.15 to $0.22 per diluted share.

Opened 11 new stores and grew shareholder equity by 39% to over $0.5 billion.

Looking to the future, we have often repeated our strongly held belief that our competitive advantage is the ability of the brand teams to deliver a shopping experience that is both differentiated and emotionally compelling.

This year's exceptional third quarter results profoundly reinforce that belief.

We have also repeated our belief that all of our brands are in an early stage of growth.

We believe our opportunity to grow the retail business by opening new stores to expand the direct to consumer business and to augment the Free People wholesale business is more than sufficient to fuel our growth goals for many years to come.

Our goal is to continue to grow revenues at a compound annual rate in excess of 20%.

And to increase net income at a rate faster than the growth rate of revenues.

To accomplish these goals, we must continue to open new stores.

Next fiscal year, we plan to open 32 to 35 new stores.

Six to eight of which are planned to open in the first quarter.

Our real estate construction and brand teams are confident this is very achievable.

We must continue to grow the direct business, to achieve this we plan to grow total catalog distribution next year by more that 15% and increase our Web marketing efforts as well.

We must expand the wholesale business as well.

Based on extraordinary success of the hard shop concept in the 59th Street Bloomingdale's store, the wholesale team is committed to opening more hard shops within department stores next year.

In addition, advance bookings for our spring, 2006 lines are currently ahead of last year's levels.

Lastly, we must grow our comparable store sales.

Our plan, as always, is to grow the comps at a modest annual rate of 3% to 4%.

However, over the last five years, we have averaged more than twice that rate of growth.

And we will continue to develop merchandising and marketing initiatives designed to maintain our historic rate of growth and store productivity.

In conclusion, we are extremely pleased with our record third quarter results.

We have created three very powerful brands.

Each has significant opportunities for future multi-channel expansion.

And we're confident that we can seize those opportunities and continue to deliver solid financial results in the future.

That concludes my prepared remarks and now we would love to answer your questions.

Are there questions?

Hello?

Yes, sir. [OPERATOR INSTRUCTIONS] And we'll take our first question from Janet Kloppenburg from JJK Research.

Dick, if you could spend a few minutes talking about the gross margin in the quarter?

And how much of it came -- the decline came from the pure product markdowns as opposed to the fuel surcharges and occupancy charges?

And with respect to the inventory levels, moving in to the fourth quarter, if you could talk about the level of markdowns this year versus last?

And your outlook for gross margin improvement in the fourth quarter?

Okay, Janet, I'm going to ask John to talk about that, if you don't mind.

I don't mind at all.

Thank you.

Okay.

John?

The bulk of the margin impact, Janet, was definitely through markdowns.

We got a little heavy on inventory and we cleared the inventory during the quarter.

And it was really not a matter of not having good selling items.

It was more a matter of having a bit too much of some of those items.

We’ve taken care of that.

And so that was the majority of it.

There really wasn't any other element that was a significant piece.

And how did -- what is the weight of the -- or the level of markdowns that are incorporated into the inventory numbers now versus last year?

And the outlook for the gross margin in the fourth quarter?

Well, we don't give that information exactly.

The level of markdowns in the third quarter was up over 1% of 1 full percentage point over the prior year.

Okay.

We believe that we have the inventories appropriately valued currently to reflect any sort of obsolescence that we feel might happen in the fourth quarter.

Okay.

So we think that we're in good shape there.

The other issue, of course, that I think that some people might have is the effect of the one-time gain from the disposition of the real estate assets.

That was my next question.

Yes, go ahead.

Of course, I'm not an accountant.

I've never had an accounting course.

Right.

But we would have loved to put it below the line where we think it rightfully belongs.

Right.

However, there are some SEC and FASB rulings directly to the point.

And we were required to put it in the margin even though I think logically everybody believes that it does not really belong there.

So I -- we did put it where it is.

We're required to do that by the FASB rules and it just made what is an excellent situation even better.

Okay.

In that it shows, instead of a 20.5% operating profit, it showed a 21% operating profit.

And so we're incredibly proud of both of those.

Dick, on the store openings that were pushed into the fourth quarter, will most of those be opened before Thanksgiving?

I think that -- typically we've had some stores open in January.

And so some will open in -- before Thanksgiving.

I think we have a -- I do not know an exact amount, Janet.

I'll have to get back to you.

Okay.

But we probably have three or four, maybe five openings before Thanksgiving.

And then we will have a hiatus and open more in January.

The good news, I think, is that we plan to open six to eight in the first quarter of next year.

Already have them lined up and they should open actually fairly soon in the first quarter.

Okay.

So we -- I do not think that we've ever had a February opening, or very few.

And we will have one in the coming year, so we are very pleased with that.

Janet, actually it is going to be like six stores in November, two in December and two in January.

Okay.

And just the last question, could some of the inventory increase have to do with the fact that the circulation on some of these catalogs, well, that you are adding an extra catalog and the circ is up, so therefore the inventory levels have to be higher going into Q4?

No.

I think is different for different brands.

What happened at Urban, I'll speak for that because Ted isn't here.

Okay.

The Urban planned three stores to happen sooner than they are going to happen.

Right.

And that caused a little bit of an increase in inventory.

And I will let Glen talk about the inventory situation at Anthropologie.

Great.

Hi, Glen.

Hi, Janet.

Janet, if we look at the women's component of the inventory at Anthro, we're about 12% higher in this year than last year.

And the women's month on month continues to improve.

We were mid-single digit comps for the quarter.

Ideally, I'd probably feel a little bit more comfortable with something around 9% to 10% But -- so, we're just a few percentage points from where we would like to be.

I think we'll get to where we want to be by the end of Q4.

The remaining increase comes from home.

And home had very healthy double digit comps increases.

And I think in part due to the fact at that we actually own the inventory.

We've upped some of the floor quantities and I feel very comfortable with those levels.

Great.

Thanks so much.

No problem.

Thank you Janet.

Thank you.

And we'll take our next question from Jeff Black at Lehman Brothers.

Go ahead, please.

Yes, good morning.

I guess this is a question for John.

Can you give us a breakout of the AUR versus transactions at both Urban and Anthropologie?

And then looking at Urban, do we have confidence that we can see, are seeing a lift in transactions that can offset the AUR increases that you started putting through in the back half of last year?

Thanks.

Yes.

That was actually one of the positive things about the quarter, Jeff.

Is that as you remember last quarter Urban's growth -- sales growth basically came from average unit retail.

And they had a negative transaction component.

But this quarter the transactions were up 4.5% for Urban while their average unit retail was up 12 and their UPT's were up two.

So very positive numbers for Urban.

And Anthropologie continued to grow in terms of transactions and price points, so their comps came from a combination of the two.

Great, thanks a lot.

Sure.

Thank you.

And we will take our next question from Barbara Wyckoff at Buckingham.

Hi, everyone; congratulations.

Question about the margins.

The margin differential wholesale versus retail and how does the wholesale business breakdown, specialty versus department stores just percentages, I guess?

Okay.

We'll take -- John, do you have that information with you?

On the margins?

The margins.

Sure.

I can give you that.

Why don't we have Chris talk about the difference between the specialty stores versus the department stores first.

Okay.

Sure.

During the quarter we saw growth through both.

We really have seen growth come through increased order size of the accounts, primarily due to the strong sellthrough we've been having.

On the specialty store side, again we've been seeing it primarily through lower per unit buys, not really an increase in the account base.

And on the gross margin, wholesale continues to grow, and gross margin rate, but still is not quite up to retail at this point.

All right.

And then what percentage are department stores of the total wholesale business?

Just over half right now, right around 50%.

Okay.

And then just a quick follow-up question, on the Bloomingdale's Free People hard shop, did they build it?

Did you contribute to the building?

What are the plans going forward?

Barbara, we contributed and they contributed and so it was a shared expense.

We're in discussions with them now with regard to our plans for next year.

But I would guess that we'll do this in several other locations.

I just heard from the Bloomingdale's senior management team last night, Terry Lundgren and Sue Kronick who had just walked through the store.

They were extremely impressed.

The performance of the shop is exceptional and so I encourage everyone who has access to New York City to go and visit it.

It is pretty terrific.

Great.

I look forward to seeing it.

Thank you.

Thank you.

Thank you.

And we will take our next question from Neely Tamminga with Piper Jaffray.

Thanks, and let me add my congratulations.

Can you talk a little bit maybe about -- in Ted's absence, can you talk a little bit about what it is going on at home at Urban?

Kind of what some of the changes that he has been seeing?

And as you head into the holiday, how you fell about that business?

And then John, if you could just review again the schedule for us and the software and systems improvements for the next, call it six quarters?

That would be great.

The home at Urban had one of its first positive comp weeks last week, so we're very encouraged.

We have been bringing more merchandise and product in as I suggested in my opening remarks.

The comp store inventories were pushed up, the holiday merchandise was pushed up by a week or two.

That was one of the areas that was pushed up at home and Urban and at Anthropologie.

And so the comp inventories are up.

And we seem to be getting a sales increase from that increase in cost inventory.

So I guess overall, I think we still have a ways to go in the Urban home area.

But I think we're seeing some light there.

And on the IT initiatives, things are going very well.

We're putting in the warehouse management right now in South Carolina and that seems to be working well.

The -- there are a number of other initiatives.

The point of sale systems will be going live next April in all our retail stores and we're very excited about that.

So, right now the initiatives seem to be going very well.

We're still contemplating the loyalty program with Anthropologie at some point next year.

Haven't finalized a decision on the software package for that.

Thanks.

And have a great holiday.

We will take our next question from Kimberly Greenberger with Smith Barney, please.

Great.

Good morning.

Please excuse my cold here.

I'll try not to sniffle on the call.

Good morning, Kimberly.

I hope you feel better.

Thanks, Dick.

Dick or John, could you talk about IMU in the third quarter?

It sounded like you continued to see IMU improvement in the quarter.

And if you would just comment as to whether that continues at the same rate that you saw earlier in the year?

And then as you look at inventory growth in the Urban Outfitters business versus Anthropologie, do you feel like you've got enough inventory at the Urban Outfitters division given the strengths in those comps there?

That would be helpful to understand.

And then, Glen, if you could you talk about the strategy in increasing your home inventory?

Is there some seasonal product that you bought into this year or what was the strategy around the investment in home as we go into the holiday?

And looking back at third quarter for the Anthropologie business, what sort of insights did you have about the way that the business progressed, that might cause you to adjust how you're managing that business going forward?

Thanks?

Okay, Kimberly.

I'm going to try to remember each one of those questions.

But I'm going to start off with the IMU.

The IMU was ever so slightly -- I guess we'd put it down from the prior year.

And as I alluded to in my opening statements, that it -- some of that had to do with the freight surcharges that we are now receiving.

And some of it had to do with airing more product rather than boating it.

So, I think that these fuel surcharges, I don't see them abating any time soon.

We have actually -- while we are on this call -- a session with all of our mills and many of our manufacturers going on here in Philadelphia.

And certainly one of the objectives is to make them aware that they've got to sharpen their pencils as well.

And so we are very hopeful that we are going to continue to see margin improvements in the coming quarters, despite the fuel.

Now, Glen, I think there was at least two questions there for you.

Hi, Kimberly.

It's great to hear your voice.

In terms of the home inventory, it -- as Dick said, we brought fall in earlier this year than we did last year.

And we brought holiday in earlier than we did last year.

I think that we do have an opportunity to cut weeks of supply in home, and we're working on making that happen gradually through the first quarter.

But I feel comfortable with the product that we own.

The business is extremely healthy.

In terms of overall strategy for Q3, I think that there are lots of opportunities.

I think 7% comp on a 22 from the prior year is a reasonably good number.

We've literally doubled our productivity in the last five years.

But we're never happy particularly with single digit performance, even though we planned that level.

I think that we missed areas in the women's business and in the accessory business.

You heard Dick talk often about the target and the bull's-eye.

We hit the target but we didn't hit the bull's-eye.

I think we're very, very clear.

I think -- I visited many of the stores with you.

I think that the store looks -- in the women's area looks much better than even it did two, three months ago.

And I think we're clear about what we need to do going forward.

And then just lastly just on the Urban outfitters inventory, do you feel like you have enough inventory in that division to support the comps that they are running there?

Yes.

There is no question that we have enough.

As I said, there were three stores that had been planned to open in the late third quarter, early fourth quarter.

And those stores have slipped out to either fourth quarter late or early first quarter of fiscal year '07.

And so we have that inventory.

You also understand that we didn't anticipate Katrina.

So we have a full load of inventory for the New Orleans store, which luckily is going to, I hope, reopen this week.

Hopefully there will be some customers down there.

So we -- yes, there are a number of reasons that Urban has a reasonable amount of inventory.

We actually want to increase the terms at Urban as well.

Their inventory -- comp inventory is up, just almost in line with the comp sales increase and we never liked that situation.

We want comp sales increase to exceed inventory increase.

Great.

Thanks so much, Dick.

Sure.

Thank you.

And we will take our next question from Betty Chen of SG Cowen.

Go ahead, please.

Hi John, hi, Dick.

I was hoping that you could talk perhaps any indications that you've gotten from the catalog so far that could perhaps give you some confidence (technical difficulty)?

And obviously the catalogs look great with a lot of the new, great items.

So maybe any color you could give would be very helpful.

Okay.

I'm not going to be able to give you that for Urban.

If you call in a few days, and Ted I'm sure would be delighted to talk to you about that, but maybe Glen will talk about Anthro .

We're extremely pleased with the performance of both our gift book and our winter book.

And our gift book dropped about four weeks ago.

The second mailing will drop in another week.

Our winter book dropped about a week ago.

And the -- both books are performing well.

There is a -- I'm always excited when there's a change in fashion, and there is change in fashion.

We won't speak to what the changes are.

But we can certainly tell you that there's change.

And there's just a lot of excitement in the air.

And are you still seeing solid response in some of the higher-priced items as you had in the previous books?

Yes.

In fact the number one item in the winter book is one of the most expensive items in the book.

So when the item is right, there is generally not a lot of price resistance.

And as John alluded to earlier, it has been a long term strategy of ours to slowly grow the average unit price over time and we continue to do that.

Great.

Thank you.

And we will take our next question from Gabrielle Kivitz of Deutsche Bank.

Go ahead, please.

Hi, you guys.

Congratulations.

Thanks, Gabriel.

How are you?

Great.

And so I had one follow-up question on the IMU part and then another second question.

So first on the IMU, I guess I was under the impression that are you still negotiating better on the costs.

And I just wanted to get a sense of how far along you are on that initiative and how far you have to go?

And then the second was just a follow-up on the air freight that you mentioned.

Maybe you could just give us some more -- was that just to -- maybe give us some color as to why you did that.

And then the second question is on sales per square foot productivity at both Urban and Anthro.

Where are we there and where do you think each of those can go at this point?

Why don't you start with that John.

On the sales per square foot, Anthro right now is probably approaching $800 a selling square foot, Obviously that's on an annualized basis.

And Urban's numbers right now are over $700.

So they've made great strides.

Both business are running sales per square foot that are probably premier in the industry.

And one of the things I'm really excited about with Anthro is that the new stores are as productive as the comp stores.

So I think that that is something that we've worked very hard to accomplish over the last few years.

And I'm really happy with that.

Great.

We should probably also mention Free People.

I focused on the other two.

But Free People's numbers are spectacular.

They're approaching $1,000 a selling square foot, some of the stores over that.

I've said in a couple of conferences, our disappointing store is about 700.

So, not bad.

Great, thanks.

And I think that looking at the overall IMU, and what our opportunities are there, I can't say it's unlimited because that would be a lie.

But it's close.

We think we have many hundreds of basis points of IMU opportunity based on procedures, technology and just partnering with our suppliers.

So, we're by no means done with IMU increases.

I think that we probably didn't do quite as good a job as we should have done concentrating on increasing the IMU.

And certainly that directive has been sent down through the ranks.

And I think people are concentrating on it again.

Okay.

Great.

And then on the air freight piece?

It's just typical freight coming in.

There's nothing unusual about it.

And we're just seeing in every place we go, air freight, truck freight, boat freight, no matter what it is, we're seeing surcharges and increased costs.

But you did more air freight than you had in the past?

Well, a little bit.

It is not that excessive.

It's is a very, very minor piece.

So, it is overall skilled costs is --

Yes that's the culprit.

Okay.

Great.

Thanks, Dick.

Thank you.

And we will take our next question from Richard Jaffe of Stifel, Nicolaus.

Go ahead, please.

We're still Legg Mason.

Give us 30 more days.

Hi, Richard, how’re you doing?

Great, thank you, and congratulations.

A question about the direct business.

There's obviously new DC's in place.

The opportunity in the fourth quarter, vis-a-vis last year for direct, I mean it seems like you had to give up some business last year.

How high is up for direct this year, or how have you planned it?

Well, we think we can have very significant increases in the direct business.

We've been running, as you know 30%, 40% up.

And we don't see any reason that we shouldn't achieve those kind of gains.

The good news is the call center and the fulfillment center are open and operating nicely.

And in South Carolina we're getting some increased efficiencies from being there.

And we've put in the warehouse management system.

It's still got a few bumps here and there.

But we feel very confident that those bumps will be out by Thanksgiving time.

We are shipping Free People and Anthropologie through the new WMS system.

And we'll still shipping Urban the old fashioned way.

So we're -- while we're using the two different systems, that will cost us a little bit extra.

We won't get quite so much return this year as we had hoped for.

But we feel it's much more reasonable to do this rather than risk some sort of blowup in the fourth quarter.

And so we're feeling confident that we can handle all the calls that we're going to get.

We can handle the shipping and fulfillment that we are anticipating.

I continue to believe that the direct business is, for many, many, many people the preferred method now of shopping at holiday time.

So we would anticipate seeing increases year after year for the foreseeable future.

Just to remind me, wasn't it in the last week of -- or the week before Christmas that you had to shut down the distribution center because you could not fulfill orders?

Yes, that was two years ago Richard.

Two years ago.

Time flies.

Last year we fulfilled all the orders but we spent a lot of money doing it because we had to hire an enormous number of temps, and temps are nowhere near as productive, nor are they as accurate.

This year we feel much more confident about our ability to leverage the space, and to leverage the technology we have in place.

And you’re operating with a separate inventory down in South Carolina?

Totally different.

And quantity-wise, is that up dramatically this year, up comparable to the regular stores?

It is up comparable to the sales trend in the direct business.

Thanks very much.

Thank you.

And we will take our next question from Jennifer Davis at Sanders Morris Harris.

Go ahead, please.

Hello, Jennifer.

No Jennifer.

Ms. Davis, your line is open.

Go on to the next call please.

Yes, sir.

We will take our next question from Dana Telsey of Bear Stearns.

Good morning everyone, and congratulations.

Can you talk a little bit about the performance of the mall versus street location stores and how you see those?

And also for next year, what the breakout will be?

CapEx, is it still around $100 million for this year and what are you looking at for next year?

And lastly, how is international doing?

Great questions.

The mall stores as I told you, are just doing phenomenally for us.

I called out two Urban stores that opened in this quarter, one at the Somerset and the other at Tysons.

They both are spectacular stores in terms of performance.

The fellows that operate Tysons Corner gave us a combination of the best new store, both Urban and Free People in their mall, in the expansion of their mall.

They sent an email around to all of their real estate friends talking about how good the stores were.

And the customers are responding in kind.

Tysons is an excellent mall for Urban and Free People.

As I told you, Tysons Free People was the highest opening, and they are consistently one of the highest of the five stores.

So the malls are doing great for Urban and for Free People.

I told you that the mall that Anthropologie opened in was the single largest opening in the Company's history.

And it was just an amazing day -- I don't quite know how they handled it.

But the malls continue to be good performers.

The return on investment continues to outperform other stores.

We just are very cautious, as we always have been, as you know, Dana, that we done want all mall stores.

That we want street locations as well because of the brand effect.

On the CapEx question, it looks like we are tracking towards that 100 million.

It may be a little lower or a little above but it will be right around that level for the year.

And your last question was international?

Yes.

The international group is going great.

We opened stores in Birmingham, and we probably open in the next week in Manchester.

In a period when UK retailing is struggling, I think we're one of the standouts.

Our comp store sales in the UK are very strong.

And then as you look at the consolidation of department stores, is perhaps the differentiation in your product, are you seeing more opportunity from vendors coming your way wanting to sell into Urban or Anthro, either their brand or your brand?

Absolutely.

I -- even though I'm not involved in it anymore, because I wasn't a very good buyer when I was doing it and even worse now -- I get calls constantly from vendors who are trying to get appointments around the backs of the merchants.

So I feel it very acutely that the vendors are struggling.

And many of them are either having the strategy of trying to go after stores like ours.

Or many of them are opening their own shops as a result of what is happening in the department store world.

On the flip side of that, we're getting an awful lot of interest, I should say, from many of the remaining department store groups in carrying Free People.

And in that area, we don't feel comfortable yet going into some of the other department stores where -- we're going very slowly and deliberately and maintaining the brand.

Thank you.

Thank you.

And we'll take our next question from Margaret Mager of Goldman Sachs.

Go ahead please.

It must be -- feel great to have a record quarter.

That's terrific.

Thank you.

A couple questions.

Do you give -- do you do same store sales by month?

I know you gave them by concept.

But do you talk about how it progressed over the quarter?

We have.

I can tell you that August and September were almost identical.

And October was a little less and that was somewhat a result of what we don't usually talk about, which was weather.

The weather in October, in the southeast particularly, was kind of brutal and caused some problems.

And probably cost us, I would say, 2 to 3 percentages in comps.

All right.

And so I -- while it was a little -- probably October a little bit weaker, I would say that in general it was pretty consistent over the period.

And on a two year basis, Margaret, October was the second best month of the quarter.

So in spite of the weather and everything else, it was -- that was really pretty encouraging to me.

Okay.

With regard to the environment, clearly the weather was an issue.

But some of the retailers are talking about holiday season being very promotional this year.

How do you -- how will that impact you?

How do you think about a promotional environment in your -- in the context of your business?

Well, we've had years before when we've had promotion upon promotion.

We've had years before when some of the major players in the department store world particularly, were going bankrupt and basically had half price off on everything.

We look at it as we always look at it, as we can't control what other people do.

We -- our job is to maintain our brand and our brand image.

We think that there is no question that some of the customers are feeling some of the gas pains -- the price of gas pain.

But I don't think -- we see the customer as still pretty strong.

Okay.

And if we have the product they want, there is absolutely no price resistance.

Okay.

That's good.

Thanks.

With regard to the Urban Outfitter stores that opened up late or are going to open up later than you expected, what are the characteristics of those stores, why is that happening, and did you include them in your 4Q store count or 1Q?

Well, we said from the very beginning of the year, actually last year at this time; we said we'd open between 30 and 32 stores this fiscal year.

And we're on track to do that.

We may even go one or two over.

So it's just really timing.

And what is the - - what has happened in the timing is that, in a number of the stores the landlords didn't deliver basically what they said they would deliver when they said they would.

And we've had some issues there.

I don't think it's any -- as I said, it's just a timing issue.

It can cause some temporary dislocations but nothing to worry about permanently.

What it is really going to do is take a couple of stores that we thought we might get open this year and throw them into the first quarter of next year.

And that's not a bad thing.

Okay.

The -- I take it those are non-mall locations?

Not all of them.

Okay.

I have a question on your inventory.

The -- you said that the value of the inventory is up a greater percent than the units on the inventory.

Why is that?

The price point?

The price point, the AUR is up.

Right.

But what is it that's up?

What's driving it?

You mean what are the items that are driving the price point increase?

Yes.

Is it a category?

Like, if you can give me some sense of it.

Glen, do you know?

In Anthropologie Margaret, it is really no one specific category.

It is probably across 15 or 20 different categories.

And it is a very, very deliberate attempt to continue to drop inexpensive things and continue to test higher price points.

Okay.

And at Urban I believe, and I could be incorrect about this, but I think it's mostly in the area of accessories for Urban.

Okay.

That's helpful.

Thanks.

And lastly, you did mention that some of the best performing areas at Urban was accessories.

I was just wondering, can you talk about what in accessories is trending really well?

And how as a percent of the mix, what's going on with accessories year-over-year?

Well, there's a number of classes within accessories that are performing very well.

But as you know, Margaret, we never talk about that for competitive reasons.

And I think it is interesting to note that accessories at Urban is the area that is, from an AUR point of view, up the most.

And it's performing the best.

So, it's another indication that the customer, I don't think is promotionally oriented.

Not the Urban customer and not the Anthro customer.

It is more product oriented.

They want what they want and they'll pay for it.

And it's our job obviously to give them that.

They don't mind paying more money for those things they want.

It is interesting that there's, in demand, any real issues with accessories at all in the environment across the category.

But thank you very much and all the best in the holiday season.

Thank you so much, Margaret.

Same to you.

Okay.

Thank you.

And we will take our next question from Holly Guthrie of Morgan Keegan.

Two questions, first gross margins, you guys have been posting really exciting gross margins, 41%, 42%, 43%.

I was wondering if you could talk about where you think you can go from here, and how -- you talked a little bit about IMU and sharpening your pencil there.

But what else you can do for -- to keep margins going?

Well, I think the 41, 42 kind of number, we think there's significant upside to that, as Dick mentioned earlier, from the markup side and a better costing and all the process that we're going through.

We think that, as we've added the new planning and allocation system and we'll be better at our allocation by store, that we think there's an opportunity in the markdown line too.

So to give you an exact number, I don't know what we'd say.

But I think it is in the hundreds of basis point opportunities on margin going forward.

It absolutely is.

You've got the initial margins as we've already discussed and you've got hundreds of basis points there opportunity.

We have opportunity in markdowns as John just talked about.

And I was out at the St. Louis store a couple of weeks ago and they were telling me that, please send us more larges.

And we still -- we just put in the allocation distribution package.

We're now trying to cross-reference that because we know the Midwest needs more larges.

We're trying to cross-reference that with the buying so the buyers can put in just in separate prepacks for the Midwest.

So these are the kinds of things that they are very, very minor, small things.

But when you add them all up, they can mean many basis points.

We are probably not going to have any help with store occupancy costs.

We're not looking to necessarily leverage a lot there.

We're not looking to -- certainly will not get any help in freight.

It's probably only going to go up as inflation kicks up.

But we can leverage things like merchandising costs.

As we get bigger, we don't necessarily have to grow our organization quite as quickly.

So there are a number of areas that we think we can make a lot of progress.

But I would say the IMU is the number one source to look for.

Great.

Thank you.

And then --

One comment on the occupancy.

Just -- because Dick's right, this year we aren't going to leverage much in occupancy because we had to expense 30 new stores.

That was a brand new change in the accounting policy.

A clarification, John.

Excuse me, clarification.

But going forward we're not going to be dealing with 30 stores that are incremental, we'll be dealing with six.

And so there may be an opportunity to leverage going forward year to year.

Great.

And then on SG&A.

Your SG&A ratio was very impressive this year and I know you guys have been working hard moving facilities, putting new systems in.

Can we -- do you think going forward we can look for a -- kind of a more moderate SG&A increase versus all what you experienced last year and in the first couple of quarters of this month?

Well, we leveraged SG&A.

We have significant leverage in SG&A.

I would say the SG&A area is really dependent on the comps.

If we achieve our 3% to 4% plan, we're probably not going to see any leverage in SG&A.

To the degree we get up into the, as we call it, significantly exceeding our plans, I think we still have lots of opportunities to achieve some leverage.

So, given the fact I can't give you a crystal ball where next year's going to be, I cannot tell you what SG&A is going to do.

But we do -- the reason we plan for 3% and 4% comp store increases is just that.

So we don't -- it doesn't get out of control and it doesn't deleverage.

Okay.

And then just one question for Glen, could you talk a little bit about some of the product misses in the third quarter?

Was it the style?

Was it fit?

Was it color combination?

It was mostly style, Holly.

I think we -- as I spoke about it on the last call, I think we brought fall in too early.

I think we didn't manage the investment by concept as optimally as we could have.

And I think we missed some style opportunities.

Great.

Thank you.

I think the good news Holly is when you look at it, as Glen says you've got maybe the fourth or fifth ring from the center, you still are achieving 7% comps.

Which is almost double our plan and so that's -- as they say, that ain't bad.

No.

And good luck this holiday.

Thank you.

And we will take our next question from Brian Tunick of J.P. Morgan.

Go ahead please.

Two of them.

First one, given this is the first time it looks like gross margins were down, I think we've said over 20 quarters now, which is pretty phenomenal.

So, congrats on that.

But going forward now could you give us on the fourth quarter, the drivers perhaps?

How much Anthropologie carryover you guys are still carrying into the fourth quarter?

Did you take your markdowns already in the third quarter?

So, just again trying to get some more color on why or what expectations would be for fourth quarter gross margins?

And the second one is just maybe talk about the sequential deceleration in the direct business.

Was there a change in the mailing schedule?

Just what happened in the third quarter?

Thanks very much.

Well, I think as to gross margin I think, as I said, we didn't emphasize enough the increases in initial margin that might have offset the increases in markdowns.

We believe that our inventories are fairly valued, right now, and anticipate the kinds of issues that we -- that we believe will happen in the fourth quarter.

And so to the degree we think that additional merchandise will be marked down in the fourth quarter, we've anticipated that and fairly valued our inventories.

I think in terms of store occupancy costs, et cetera, John has gone into that.

Why there was deleveraging there, slight -- there was slight leveraging but it wasn't anywhere near what it should have been if the new interpretation of accounting rules hadn't been posted last year.

So there are a number of issues that combined.

But I would say the most important of them are the markdowns.

And we just have to get -- instead of being in the fifth rung from the center, we just have to get back to the second or third rung.

And when that happens then the -- that will take care of that.

As to the catalogs, I think the catalogs are performing as to plan.

They're not performing significantly above plan like they had been, but we're still seeing 35% increase on a year-over-year basis and we don't think that's shabby.

And that's actually -- the sales increase is greater than the catalog distribution increase.

So we're not losing leverage that way.

We're just -- we're not at all disappointed with the sales growth.

And is it possible just to ask one other question?

You can ask as many as you want.

All right, thanks, Dick.

Just on the classifications maybe between Anthro and Urban, talk about how home and the apparel business has comped at both divisions?

That would be terrific.

Right.

I -- as I said in my remarks, the Urban apparel and accessories areas were the leaders and home was down, slightly.

And as I said in one of the - - to reaction to one of the questions; last week, was the first time that Urban had had a positive home comp in a number of quarters.

So we're hopeful that that will continue and time will tell.

Anthropologie on the other hand was a little different.

The apparel did okay but not fantastic, while the home really comped very well.

So is -- there are certainly differences in the two operations.

Thanks again.

[OPERATOR INSTRUCTIONS] We'll take our next question from Adrienne Tennant at Wedbush.

Hi, everyone.

Let me just add my congratulations on a quarter well done.

Thanks, Adrienne.

Most of my questions have been asked.

And so the one that I really kind of was focusing on, as we get into the stores, what is the strategy at the Anthro division by incorporating some of the kids merchandise?

If you can talk a little bit about that please?

Adrienne, actually we intend to eliminate the kids category after holiday this year.

It has been a productive -- a somewhat productive category but we think we can take the space and the open to buys and use it more effectively.

We're actually eliminating -- we've done kind of a strategic review of all of our businesses.

And we're eliminating a couple of other businesses as well, for example pets and flush.

Okay.

So was that just a test for the fall of this year?

No.

Actually we've had kids for years.

And it's always a nice profitable business.

I just think we can use the floor space, the design time, the buying payroll et cetera more productively.

Okay.

Great.

Thanks so much.

And good luck for holiday.

Thank you.

And we will take a question from Ken Greenberger from Smith Barney.

Hi, it is Kimberly. [Laughter]

Hi, Kimberly.

I just had a couple of dry accounting questions.

Oh, man.

John, remind me, are you guys on the cost or the retail method for inventory accounting?

Well, we convert to cost.

We're on retail.

We monitor our markdowns on retail.

Okay.

So you can actually -- I'm sorry.

But then we convert it into costs.

So can you -- I'm not sure then how that works.

Can you actually reserve for future markdowns under the method that you are using?

Certainly.

Okay.

Well, we don't call it reserves, we call it fairly valuing our inventories.

Okay.

Fair clarifying.

Don't get me in trouble here Kimberly.

I'm sorry.

I don't want to go like Martha. [Laughter]

And John, is this the last quarter that you are and anniversarying that you will have this change in lease accounting that's impacting your occupancy?

I think you started -- you sort of changed it in fourth quarter last year?

Well, this is the last quarter where it will impact us to the degree that we were impacted.

In other words, this is the last quarter where we're up against a different method of accounting from the prior year.

Into the fourth quarter, we're up against the same methods of accounting on a year-over-year basis.

It still penalizes companies that are growing.

So to the degree we're opening more stores this year than last year, then we get penalized.

But we only get penalized by the differential.

Okay.

Does that make sense?

Yes.

So it's just a little bit of a drag versus the Q1, Q2 and Q3 this year, it was more of a drag.

Well, our accounting department thinks it's a big drag.

And then any preliminary idea of what you expect options expense in 2006 to be?

Option expense?

I would say that option expense would be relatively low in 2006.

I think we've come up with a number of about $1 million because we're not issuing new options in 2006.

Okay.

So just 1 million of expense.

Yes.

Great.

Thank you.

Thank you.

And we will take a follow-up question from Jennifer Davis of Sanders Morris Harris.

I had a couple of quick questions and I had to hop off the call for a minute so I'm sorry if you already answered this.

No problem.

But did you give the dollar increase in inventory excluding Anthro's home or do you have that?

We did not.

It was 18% excluding Anthro's home.

For a total comp.

Okay.

And for Anthro, instead of 20 it was 12.

What was that, 12?

If you just look at the Anthropologie and you take out home, it was 12% up.

Okay.

And do you have the carryover inventory levels?

Are they down?

I think we're going to have to get back to you on that question.

Okay.

Okay?

Thank you.

Have a great holiday season.

Thank you so much.

Thank you. [OPERATOR INSTRUCTIONS] We'll take a follow-up question from Gabrielle Kivitz of Deutsche Bank.

Go ahead please.

Just a follow-up question on the outlook for comps and specifically the home business.

Just because I'm remembering that home business, specifically in Anthropologie showing a pretty wide swing over the last couple of years.

I feel like a couple of years I remember it significantly underperforming and it had a really nice turnaround.

And I'm just wondering, what do you think the difference is between the home business at Urban and Anthro?

Is it internal, is it external?

I know that you guys typically do not like to talk about external trends because you are much more focused on what can you do internally.

But I'm just wondering if maybe you can talk about, why the Urban business or home business specifically has been underperforming relative to the Anthro home business?

And what the -- can we really see some sort of dramatic swing in that business maybe next year?

In the Urban business, dramatic swing?

Yes.

Just because we --

I don't know that I want to tell that you there's going to be a dramatic swing.

I think the difference is that Glen made a change in the home merchant area -- and we're talking people now -- a change in the home merchant and the home design structure two years ago.

And Ted made that same kind of change less than one year ago.

And so I think that we're hopefully going to see the effects of that change at Urban this year coming up.

So fiscal year 2007.

And I think what I just told you, which is, we saw the first positive comp.

I hope we're beginning to see the effects of it a little sooner than 2007.

Again the -- time will tell whether that is the case.

But I think that there's opportunity there.

There's no question in my mind there's opportunity.

I think it's a lot to do with people and structure and execution.

And so there's -- and I certainly don’t want to blame anything on external situation.

Do you mind if I ask though, do you think that there's anything different --?

You can ask anything you want.

In the home area in the youth market versus the Anthropologie customer?

Do you think there's anything just external that's different?

Well, I think the kinds of products they want are very, very different.

The aesthetic is, I think, extremely different.

But that doesn’t say that one should be better or worse.

I think there's opportunities for both to very well.

And I think that as I said, Urban took an extra year in coming to the conclusion that there should be some restructuring.

And the restructuring, hopefully, will result in improvement in the area.

Thank you, guys.

Good luck.

And it appears we have no further questions at this, Mr. Hayne.

Thank you very much.