Vera Bradley Inc (VRA) 2016 Q1 法說會逐字稿

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to the Vera Bradley first-quarter 2015 earnings call.

(Operator Instructions)

As a reminder, today's conference is being recorded.

I would now like to turn the call over to Julia Bentley, Vice President of Investor Relations and Communications. Please go ahead.

Good morning, and welcome, everyone. We'd like to thank you for joining us for Vera Bradley's first-quarter earnings call.

Some of the statements made on today's call during our prepared remarks and in response to your questions may constitute forward-looking statements made pursuant to and within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, as amended. Such forward-looking statements are subject to both known and unknown risks and uncertainties that could cause actual results to differ materially from those that we expect. Please refer to today's press release, and the Company's Form 10-K for the fiscal year ended January 31, 2015, filed with the SEC, for a discussion of known risks and uncertainties.

Investors should not assume that the statements made during the call will remain operative at a later time. The Company undertakes no obligation to update any information discussed on the call.

I'll now turn the call over to Vera Bradley's Chief Executive Officer, Rob Wallstrom.

Thank you, Julia. Good morning, everyone, and thank you for joining us on today's call. With me today are Kevin Sierks, our Chief Financial Officer, and Sue Fuller, our Chief Merchandising Officer.

Excluding the charges outlined in this morning's release, we achieved first-quarter diluted EPS at the low end of our guidance. Reduced promotional activity led to better-than-planned gross margin rate performance, while revenues fell below our expectations.

We continue to make progress on our key initiatives. It is frustrating to us, and I'm sure you, that the progress we have made is not reflected in our current financial results.

It is evident that our overall business trends remain difficult. We are not attracting enough new customers to the brand, and traffic and sales are still very challenging. Our marketing initiatives will continue to accelerate throughout the year, with our first significant investment in conjunction with Mother's Day at the end of first quarter.

Let me take just a minute to let you know what customers are telling us. We have conducted several surveys and focus groups with both lapsed customers and those that have never shopped with us. The results were not surprising. Many of these consumers associate Vera Bradley only with quilted cotton bags; and overall interest in traditional quilted cotton products is not as strong as it used to be.

She wants us to scale back on, but not eliminate, our cotton offerings. She wants solids and new fabrications. She wants trendy and stylish. And she wants us to distribute our products in more locations where she frequently shops for bags, like department stores.

Once they are shown our assortments, these consumers overwhelmingly have a favorable reaction to the new fabrications and products we are offering. They are just not aware of our new offerings, which reinforces that we need to generate more exposure and brand awareness.

In addition, our department store and potential department store partners are enthusiastic about the way our product assortment is evolving. And even though reorders are running behind in our specialty retail channel, our specialty retail partners agree we are heading in the right direction. Our specialty store partners are still asking us to reduce promotional activity. And we began to make headway by eliminating our hyper-promotional -- our 60% to 70% off -- activity, and paring back our promotional days by about 15% during the first quarter.

These findings have reinforced our commitment to our long-term strategic plan. The elements of the plan are specifically designed to drive traffic, and bring new customers to Vera Bradley. We will continue to innovate and modernize our products, increase exposure to our brand and offerings by prudently growing our distribution points, including department stores, and drive brand and product awareness through our elevated marketing efforts. Sue and I will update you on our progress against the elements of our strategic plan later in the call.

Although we are executing a lot of strategies this year, we are revising our forecast down to reflect our current business trends until we gain traction in the Business. Growing Vera Bradley to a $1-billion company, generating a high-teen operating margin, remains our ultimate goal. However, until we begin to see recovery in the Business, we cannot accurately predict the timing of achieving these long-term financial targets, and won't be making any additional comments on them in the meantime.

Lastly, allow me to give you a brief update on our executive team. We have a very talented and experienced team that I believe is up to the challenge of turning the Business around.

We are really excited that Theresa Palermo will join us as Chief Marketing Officer on June 24. Theresa has a strong creative and analytical background, and comes to us from Fossil Group, where she served as VP of Global Marketing and Public Relations. Theresa has held other key marketing roles with such companies as Stride Rite, Timberland, and J. Jill.

As you know, Karen Peters, our EVP of Sales, left the Company in April. We have developed tremendous bench strength in the sales organization over the last year, including Debbie Kozlowski, who oversees our department store relationships as VP of Global and Key Accounts, Melissa Latham, who's the VP of Retail Stores, and Harry Cunningham, Head of Store Development. Debbie, Melissa and Harry each have many years of industry experience, resources and contacts.

EVP Roddy Mann, who has been with the Company for over seven years, and was previously responsible for the sales organization, is overseeing it once again. Since we have so much talent on the sales team, our current plan is not to replace Karen.

I will now ask Kevin to give us a brief update on our first-quarter results and outlook for FY16. Kevin?

Thanks, Rob, and good morning.

Before I begin, let me remind you that, as a result of moving to a wholesale business model in Japan, we exited our direct business during the third quarter of FY15, and have accounted for it as a discontinued operation. The prior-year income statement numbers I will reference reflect continuing operations. In addition, the current year numbers I will discuss will exclude the charges outlined in the morning's release related to our manufacturing facility closing, severance and other restructuring charges, and an income tax adjustment.

Let me go over a few highlights for the quarter. Net revenues totaled $101.1 million for the current-year first quarter, compared to $112.2 million last year, and our guidance of $103 million to $109 million. Net income from continuing operations before charges totaled $0.1 million or $0.00 per diluted share for the current-year first quarter, compared to $6.9 million or $0.17 per diluted share last year. As Rob stated, the flat EPS was at the low end of our guidance.

In our direct segment, total revenues of $70.4 million declined by 2.4% from last year. This revenue number reflects a 16.9% comp sales decline, partially offset by new store growth. Indirect segment revenues fell 23.3% to $30.7 million, primarily due to lower reorders from our specialty retail accounts, and the timing of our summer product launch, which shifted approximately $3.7 million of revenues into the second quarter.

Gross profit for the quarter totaled $55.1 million or 54.5% of net revenues, compared to $59.8 million or 53.3% of net revenues in the prior-year first quarter. The year-over-year rate improvement primarily related to an increased penetration of higher-margin MFO product in our factory outlet stores, leverage of overhead costs due to fall 2014 cost reductions at our domestic manufacturing facility, lower levels of liquidation sales, and reduced promotional activity. The rate exceeded guidance of 53% to 53.5%, primarily due to lower promotional activity than originally planned.

SG&A expense totaled $55.1 million or 54.5% of net revenues in the current-year first quarter, compared to $50 million or 44.6% of net revenues in the prior-year first quarter. As expected, SG&A dollars increased over the prior year, primarily due to strategic investments, including incremental marketing, new store expenses, and eCommerce investments. The SG&A expense rate was at the high end of our guidance of 51.9% to 54.5% due to the lower-than-expected sales.

Operating income, excluding the charges outlined in the release, totaled $0.9 million or 0.9% of net revenues in the current-year first quarter, compared to $11.3 million or 10.1% of net revenues in the prior-year first quarter. By segment, direct operating income was $11.5 million or 16.3% of sales, compared to $13.8 million or 19.1% of sales last year. And indirect operating income was $11.1 million or 36% of sales, compared to $15.4 million or 38% of sales in the prior year.

At quarter end, cash totaled $96.6 million, compared to $81.5 million at the end of last year's first quarter. Quarter-end inventory was $101.8 million, at the low end of our guidance of $100 million to $110 million, and compared to $126.6 million at the end of last year's first quarter.

Now let's talk about our outlook for the second quarter and FY16. As Rob noted, we have lowered our expectations for the year based on our first-quarter performance. Guidance for the year excludes the first-quarter charges outlined in the release.

For the second quarter, we expect net revenues of $116 million to $120 million, compared to prior-year second-quarter revenues of $119 million. The second-quarter revenue expectations reflect the timing of approximately $3.7 million in indirect revenues related to the early order period, or EOP, for our specialty retailers that shifted from the first quarter last year to the second quarter this year.

We expect direct segment net revenues to increase in the mid-single-digit percentage range, with a comparable sales, including eCommerce, decrease in the mid- to high-teen percentage range. We believe our indirect net revenues will decline in the high single-digit to low-teen percentage range during the quarter.

The gross margin rate for the second quarter is expected to range from 54.5% to 55%, compared to 53.3% in the prior-year second quarter. SG&A, as a percentage of sales, is expected to range from 48.3% to 49.3% for the second quarter, compared to 42.6% in the prior-year second quarter. The expected deleverage is primarily due to incremental investment in key areas like marketing and eCommerce.

We expect second-quarter diluted EPS to be in the range of $0.10 to $0.13. Diluted EPS totaled $0.19 in the prior-year second quarter.

We expect inventory to be $108 million to $112 million at the end of the second quarter, compared to $112 million at the end of last year's second quarter. This projected inventory level reflects a better balance of current to retired inventory than a year ago, and investments in key growth classifications, including new fabrications.

For the full year, we expect net revenues of $480 million to $495 million, compared to $509 million last year. Our revenue guidance includes direct segment net revenue growth to range from flat to low single-digit percentage increase, with a decline in comparable sales, including eCommerce, in the low- to mid-teen percentage range. This guidance reflects a continued reduction in hyper-promotional activity. Indirect net revenues are expected to decline in the low- to mid-teen percentage range.

The gross margin rate for FY16, excluding the charges outlined related to the first quarter, is expected to range from 55.7% to 56.2%, compared to 52.9% last year. This planned improvement reflects the leveraging of overhead costs due to a planned increase in units manufactured, although the leverage will not be as significant as originally expected, due to a more conservative approach to inventory growth for the balance of the year. In addition, the planned gross margin improvement reflects reductions in sourcing and product costs, primarily related to our made-for-outlet product, and including the closure of our domestic manufacturing facility, a greater sales penetration of higher-margin MFO product, and reduced promotional activity.

SG&A, as a percentage of sales, excluding the charges outlined in the first quarter, is expected to range from 46.8% to 47.4% for FY16 compared to 41% last year. The expected rate increase is primarily a result of the previously discussed strategic investments in the Business in FY16, including incremental marketing expense of approximately $8 million, as well as incremental eCommerce and incentive compensation expense. The deleverage reflects a soft sales projection.

We do have an active expense control program in place, and we are focused on reducing expenses. We have implemented, or are implementing, several cost reductions, including recent closing of our domestic manufacturing facility, negotiating lower prices with our fabric mills, right-sizing the support staff for our indirect channel, and gaining staff and efficiencies in our stores.

Our expectations for diluted EPS, excluding the charges outlined for the first quarter, (technical difficulty) from $0.64 to $0.74 for FY16. On a comparable basis, diluted EPS totaled $1 last year. We expect our net capital expenditures will total approximately $31 million for the full year, primarily related to new store openings, continued investment in our systems, and the recent completion of our corporate campus consolidation.

We intend to make some targeted inventory investments, primarily in the back half of the year. Our inventory is projected to grow at a faster rate than sales this year.

Let me turn the call over to Sue, who will give us an update on product. Sue?

Thanks, Kevin.

In the product area, as we market our FY16 initiatives into three key categories: delivering innovation, newness and diversification; strategically segmenting our products by channel; and enhancing our gross margin. We continue our focus on increasing the relevance of our product through innovation and newness. Our core customer is responding to the newness; and we know this product evolution is critical to attract customers that have lapsed or never have shopped with us. We are continuing to improve our internal innovation pipeline to keep fresh fabrication and style ideas coming.

Our cotton performance is declining faster than our overall business trend. At this point, the introduction of newness and innovation is not enough to offset declines of our core quilted cotton business.

Having said that, both our retail partners and consumers are telling us that our assortments have never looked better and been more trend-right, and our offerings are continuing to improve each season. I am really excited about our summer, fall and winter collections. We are moving faster, and adding more inventory in certain new products, fabrications and categories.

By diversifying into a variety of new fabrications, we believe we are now more effectively able to compete, and better positioned to take market share in the long run. By offering primarily quilted cotton products, we were only able to compete in approximately 10% of the bag market. Our expanded offerings allow us to compete in approximately 90% of the market.

As Rob mentioned, our core customer wants us to scale back on, but not eliminate, our quilted cotton offering. Two years ago, we had two fabrications in our full-line business: solid microfiber, which made up less than 5% of our fabric-based assortment, and quilted cotton, which comprised the rest. Currently, we offer five fabrications: quilted cotton, solid microfiber, leather, faux leather, and Lighten-Up. At the end of the first quarter, approximately 80% of the applicable SKUs in our full-line business is now quilted cotton, which includes our small prints, and approximately 20% is in the four new fabrications.

As we end this fiscal year, we expect our dependence on quilted cotton to be further reduced as we expand our non-cotton products, and introduce two additional fabrications: our Streeterville Poly Twill collection and our Preppy Poly collection. At year end, we will have a total of seven fabrications, and expect nearly 50% of our applicable SKUs to be in non-quilted cotton fabrications.

This fall, we are adding navy and espresso to our core microfiber assortment, and adding additional SKUs in our core color of black. Microfiber continues to be our biggest near-term sales growth opportunity.

As we elevate and innovate, leather is becoming more important for us. We will introduce our beautiful new Wildwood leather collection in July. The Wildwood price points will be positioned between our original Sycamore leather collection introduced last fall, and our North Fork faux leather collection. Both leather collections are high-quality leather, are trend-right, are competitively priced, have incredible functionality, and of course, have the signature Vera Bradley pattern on the inside.

Sycamore is priced approximately 20% below our peers, and Wildwood will be very attractively priced below Sycamore. For example, our Nora tote in the Sycamore collection is priced at $278. The comparable Ella tote in Wildwood is $198. Both are amazing values.

We are especially excited about back to school, which will focus on backpacks, and everything that goes into the backpack, including lunch boxes and stationery items. Last year, we made a significant investment in back to school by increasing our backpack assortment, adding new styles, increasing functionality, and introducing our Lighten-Up fabrication. Sell-throughs exceeded our expectations. And in units sold, we moved from the number-three women's backpack brand in the US to number two last year.

This year, we are investing even more, adding new fabrications and three new backpack styles, bringing the total number of styles to nine. In addition, we are expanding our assortment of coordinating back-to-school items.

We are getting more strategic about product segmentation. Sycamore and Wildwood leather will be primarily distributed in our full-line stores, on VeraBradley.com, and in department stores. Beginning in July, faux leather will be segmented into the specialty channel.

In addition, we are creating other specific products for specific channels. For example, we successfully launched our exclusive field flower pattern with Dillard's and QVC this spring. And of course, our made-for-factory, or MFO, product are a critical piece of this segmentation.

Our third focus is on improving gross margin. We believe our innovation and segmentation should generate higher gross margins over time. In addition, we continue to build a more flexible, efficient, and cost-effective supply chain through vendor and country diversification. We have expanded beyond China, and are now manufacturing a small amount of product in Vietnam and the Philippines, and exploring other countries as well.

The closing of our domestic manufacturing facility earlier this year will equate to annual savings of approximately $12 million, beginning in the fourth quarter of this year. We have also aggressively renegotiated pricing with all of our mills due to lower cotton and petroleum costs, and expect to save $2 million to $3 million in cost of sales on an annualized basis, beginning in FY17.

Rob?

Thanks, Sue.

Our distribution strategy remains a key element of our long-term plan. We still believe there is ample opportunity for both full-line and factory outlet store growth in the future. However, in the interim, until we change the trajectory of our comparable-store sales performance, we have slowed the growth from our original annual target of 20 to 25 full-line stores and 10 to 15 factory outlet stores.

We have plans to open 15 full-line stores this year; five opened in the first quarter, and five will open in each of the second and third quarters. Seven of these stores will be in the western United States, where we are dramatically under-represented: three in Metro LA, two in Metro Denver, and one each in San Diego and Scottsdale.

We expect to open 11 factory outlet stores this year. Five opened in the first quarter, three are opening in the second, and three are opening in the third. At the end of the first quarter, we had 101 full-line stores and 34 factory outlet stores.

In FY17, our current plans are to slow the growth even more, to a total of about 5 to 10 new stores. However, over time, we still believe there are opportunities to grow our full-line store base to about 300, and our factory outlet base to approximately 100, equating to the 3 to 1 ratio we have talked about in the past.

The first iteration of our new, more modern full-line store design was introduced in our Kierland Commons store in Scottsdale, Arizona, which opened in March. All of our new stores this year will reflect our updated store configuration and design. We are receiving positive responses from our customers on the changes. The Kierland Commons store is currently performing better than the closest full-line store at Biltmore mall in Scottsdale, so we are encouraged.

First quarter, we initiated our New Jersey project and our Dallas project, focusing on five stores in each geographic area. We completed minor store remodels to reflect a more modern aesthetic, and enhanced our merchandise presentations. We are continuing to receive very positive consumer feedback to the improvements; and in the aggregate, our Dallas area stores are now outperforming our Houston area locations. We believe changes like these are important to enhance our brand perception, and to drive more customers into our stores over the long run.

In our factory stores, we are moving faster than expected on our MFO product transition. At year end, about 25% of the merchandise in our factory outlet stores was factory exclusive, and we are over 40% currently. We expect this to increase to over 60% by the fourth quarter. We are also beginning to work on our factory outlet branding, defining the core value proposition by highlighting the design quality and competitive pricing of our MFO product.

eCommerce remains an integral component of our long-range plan. We are in the beginning stages of our 18-month conversion to a new web technology platform and our site redesign. Once fully implemented, this new platform will allow for a true omni-channel experience for our customers, with personalization and segmentation of customer experiences and offers, and better management of promotions.

Phase one will be complete in June, and we will offer significantly enhanced search capabilities. Over time, this new platform should allow us to better focus on our brand, our product story, and more full-price selling. In the meantime, we have continued to upgrade the customer experience on the web by adding additional features, such as 360-degree product views, and more videos.

In January, we began strategically paring back our hyper-promotional activity that we believe is not sustainable over the long term, and is damaging to the brand. In the first quarter, we eliminated our deepest discounts, both on the website and in our full-line stores, and reduced the number of promotional days by about 15%. This is having an impact on sales, but is the right action to take for the long-term health of the Business and the brand. We expect to continue to pare back promotions going forward.

There's a lot of excitement and progress being made with our department store relationships, which are key to our long-term growth in the indirect segment. Department stores allow us to expand our exposure, and should attract new customers to the brand. It is also a great venue to showcase both our traditional and elevated product assortments. Our department store partners are excited about our product and brand direction.

We recently added distribution to 150 additional Macy's stores, bringing our total to 250. Our footprint in these stores still averages only about 100 square feet, but we are working to expand our presence in select doors, including the 500-square-foot shop in Macy's Herald Square, which will be unveiled in September.

We are now in seven Belk doors. We will open a 500-square-foot hard shop in Belk's flagship in the SouthPark Mall in Charlotte in June. And we will test holiday pop-up shops in about 40 other locations later this fall.

And in July, we will introduce our products to 12 Bon-Ton stores, with an average soft shop size of about 300 square feet. Of course, Dillard's and Von Maur remain special partners for us, where we have distribution in all of their doors.

We continue to get strong interest from other department stores, but we are taking a methodical and strategic approach to building a profitable department store business that best represents our brand. At this time last year, we were in 311 department stores, and currently represented in nearly 570 department stores. In addition, this fall we are scheduled to launch our Vera Bradley shop on Amazon.

The indirect specialty gift channel remains an important and profitable piece of our Business. We continue to focus on our largest accounts that represent our brand the best. However, we still aren't generating the reorders we need for growth.

Our door count remains flat at about 2,700, but we are beginning to look for other appropriate specialty store relationships outside of the gift channel, such as local high-end apparel and accessories stores. In the future, our segmented product offerings that Sue mentioned should have a role in driving specialty store sales and improving their margins.

Now, let me shift to marketing, which remains one of our most critical focus areas this year, as we work to modernize our brand and attract a wider breadth of customers. As you know, we are investing approximately $8 million in additional marketing this year, with more focus on digital, social media, and key magazine advertising. We intend to increase our effective reach from 8 million to 85 million customers, particularly focusing on the 25 to 45 style-conscious demographic.

On the digital front, we are focusing on mobile geo-targeting, display banner ads, and video advertisements. A key component of our digital focus is partnering with even more influential social media stylists and bloggers.

We are also increasing our TV and product placement, the majority of which is done for free. Vera Bradley products were spotted on several popular nationally televised shows this January, including Modern Family, Big Bang Theory, 2 Broke Girls, and Mom.

Our I Am advertising campaign will launch in July, in conjunction with back to school. I Am highlights the multifaceted nature of our consumers; connecting them and their life to our brand and products. During the testing phase, after seeing the campaign, potential customers indicated an increased intent to purchase Vera Bradley.

With a positive response to the I Am campaign in the testing phase, we quickly tried to replicate the look and feel of the campaign, and place Mother's Day ads in the May issues of several fashion magazines, including Vogue, Elle and In Style. (technical difficulty) Due to the quick turnaround, the photography styling and overall execution fell short of our expectations. The ads did not represent the brand the way we envisioned they should, so we are looking forward to improved execution and effectiveness of our I Am campaign.

Our marketing efforts will build throughout the year, and will hopefully increase awareness, and drive new customers to our brand. We know it will take time. We are anxious for our new CMO to get on board, so that she can evaluate our plans, and determine what enhancements we can make to improve productivity and return on investment.

Operator, we will now open up the call to questions.

(Operator Instructions)

We'll first go to Ed Yruma with KeyBanc Capital Markets.

Hi, good morning, thanks for taking my question. Just a quick update on some of your replatformed stores. I think you did one in New Jersey. Are you seeing a different level of performance in those stores that you've touched and remerchandised versus rest of fleet?

Good morning, Ed. Yes, in terms of New Jersey, what we're seeing in New Jersey and Dallas, first, overall, is customer feedback has been incredibly positive. What they've been telling us is that both the new merchandising as well as the refurbishing, allows them to see the product much clearer. It's also attracting a new customer into the brand.

But where we're seeing the biggest results from a sales impact are on the new merchandising standards. So, for example, we did a new travel wall that we implemented in the stores. We've seen a nice lift in the travel assortments and we've begun to roll that out to all of our stores. We instituted a backpack merchandising wall that also was very successful that we've moved out across the store.

So we continue to see, again, hear positive response from our customers, beginning to get pieces of it that are really working. And we're continuing to refine that.

Got it. And two quick follow ups. First, I know you had planned incentive comp to be up pretty meaningfully year over year. Given the results, has that changed? Was there any kind of a crew reversal?

And then a bigger picture question. I understand you're not going to give us any updates on the long-term guidance, but what kind of markers should we be looking for in this period of turn to assume or to understand if you're hitting some of your internal objectives or making progress against some of these goals that you've outlined? Thank you.

Let me start with the first one with regards to compensation. You're exactly right. That did come down. We expected to have to hurdle about $7 million this year from a compensation perspective compared to last year. That number's now down to about $2 million to $3 million. That is reflected in our guidance.

And in terms of key markers, two different ways of looking at it. First of all, the most important one is going to be seeing an increase in the comp sales performance as we go forward. That will be the first place we really feel great that the consumer's responding.

In the interim, the markers that we're looking at are a few different ones. First of all, the performance of all of the new products that we're introducing. Again, during first quarter our new products met our planned expectations, which was encouraging as well as all the feedback we've been receiving from customer focus groups. So the response to the new product is one key marker.

Another key marker we talked about, the role of factory in MSL exclusives. And as we discussed, we've been exceeding what our plans were in terms of penetration of MFO, and seeing very nice margin flow-through from MFO expansion. So that is another one.

The third area that we will begin to track against is watching as the marketing gets out, watching the brand awareness, and increasing the brand awareness in particularly of the new product categories. Those are the areas that we're focusing on.

Got it. Thanks so much, guys.

Thank you.

We'll go next to Oliver Chen with Cowen and Company.

Thanks for the transparency. I had a bigger picture question on the state of the business. When you think about the needs between marketing versus product and speed.

I wanted your thoughts on where you see bigger opportunities, because it does sound like your product plan is attractive in terms of where you're headed. But it sounds like you're solving for this overall traffic and awareness and demand creation.

And then on -- I know you just mentioned Vera Bradley and Amazon. I'm wondering how this fits into your channel strategy and how products might be segmented there versus both your bricks and mortar and online. Thank you.

I want to make sure I get the question right, Oliver, and thank you for it. But in terms of what we're focusing on right now, you're right, that the number one issue is building awareness, that the $8 million that we've invested in marketing is really critical. We laid out a plan at the beginning of the year which we're executing to.

We obviously have Theresa, who's joining us. I think Theresa brings a lot of great skills to the team, particularly working at retail brands and having more of a true CRM program in place and a great balance between creative and analytical.

She's really going to focus on how do we build the buzz and the awareness of what we're doing out in the community much faster, particularly through PR. And how do we leverage PR and social media in the interim, as we are still implementing our $8 million marketing investment.

So that really is the critical initiative this year, as we've talked about, the unfolding of our plan. The marketing is definitely key to building the awareness, because we believe that the product has started to get to where we need it to be.

We've received a lot of great response. We think we're going to continue to innovate. Sue and the team are doing a great job of driving innovation and we will continue to innovate. But we do believe that the primary focus is building awareness.

Regarding Amazon -- yes, go ahead.

(Technical difficulty) are you feeling like traffic is an opportunity across all the channels (technical difficulty) more you see bigger opportunity for improvement there as marketing (technical difficulty) impact?

Yes, we definitely are seeing traffic, really, across all of the channels right now being challenging. It is interesting, though, for example in our department store environment where traffic is much more stable, our business is stronger within the department store channel. Which, again, I think speaks to the importance of getting consumers in. So we do expect that where we should see the first influx of traffic would be through our eCommerce site followed by our own full-line stores.

One of the pieces that we have to break down in eCommerce, though, is that hyper promotion has been the primary traffic driver, and we are severely dialing that back. So that is one lever we're pulling off of eCommerce as we begin to build awareness to get a new full-price customer in. That one is a little bit quicker to look at the macro traffic number. We have to look underneath it and separate the hyper-promotional traffic from the full-price traffic.

Thank you.

Thank you.

And if you could talk about the Amazon topic, that would be great.

Yes, as we look at all of our channels of distribution, we definitely are looking at product segmentation. The product that Amazon will go up with is definitely a limited assortment. We made sure that it's really focused on our freshest product and our newest product.

Again, we believe the number-one thing we need to do is get in front of a new consumer. We need to let new consumers see our product. Obviously with Amazon's very large reach, we feel it's an opportunity to put our product in front of new customers. That's what we're really using it for, is a marketing reach.

Yes, and Oliver, from a sales perspective, we obviously expect it to be fairly small this year. It will be in the indirect segment, from a segment perspective, if you're looking at modeling.

Okay. And Kevin, just a final question. As we model, it sounded like you're on track to introduce some good products. Where does inventory -- what does it do to your networking capital this year? And are there any guidelines for the cash flow from operations this year in terms of (technical difficulty)?

Yes, we definitely expect to grow inventory this year, and obviously profitability is down. So from a working capital perspective, generally speaking, I expect it to be negative this year, namely because of inventory growth in the back half of the year to support a lot of the new fabrications and the new product that's working. But we don't give guidance for the full year, but you can obviously expect it to be much lower than last year and even lower than the prior couple years, from an operating cash flow perspective and free cash flow perspective.

And then as far as inventory, Oliver, our current to retired inventory continues to get more and more positive. We moved a lot of our liquidation inventory last year. If you look at the health of our inventory, that's not something keeping us up at night this year like it maybe was last year.

We continue to improve assorting by channel as well, and Sue and team has done a great job improving there. Over the long term we expect inventory to grow with sales, but this will be the sixth quarter here in Q2 where inventory's actually growing less than sales, or actually been reduced actually, quarter-over-quarter. So expect in Q3 and then in Q4 for inventory to start to grow slightly higher than sales.

Okay. Thanks for the color, and the details on the freshener. Thank you.

Thank you, Oliver.

We'll go to Ike Boruchow with Sterne Agee.

Hey, guys, it's actually Tom Nikic on for Ike. Thanks for taking our question. Just a bit of housekeeping. I think I may have missed the guidance for the indirect sales in Q2. Would you mind just repeating what the guidance was for Q2?

Sure, no problem. It's down high single-digits to low teens.

Down -- okay, got it. Also, okay, now my actual question. So your gross margin guidance seems to imply a lot of improvement in the back half of the year. I understand some it is the MFO penetration, and some of it is the pullback in promotions. But what continues to give you confidence that you can get hundreds of basis points of gross margin in the back half of the year, given some of the top-line trends that you're having, and some of the difficulty on the top line? Thanks.

Yes, good question, Todd (sic - "Tom"). I mean, the real thing we saw in Q1, which Sue mentioned on the call, is we've seen a lot of good success with MFO. Not only is it selling very well from a productivity perspective, we're seeing a 3% to 4% higher margin on that product.

And our penetration is a lot higher. We thought we'd be at around 30% to 40% in the quarter and we're actually north of 40% in the quarter. And now we expect it to go above 60% as we get to Q4.

So MFO alone is over 1%. It's about 1.25% improvement this year compared to last year. That's the single largest item.

Another thing is closing our domestic manufacturing here in town. A lot of that hits in Q4, but some of it does hit earlier in the year just because we reduced second shift back in October. That's beginning to benefit us here in Q2. We'll get about, call it, 70 basis points improvement from the manufacturing facility being shut down.

The remaining, call it, percent is really around some operating efficiencies. That's came down a little bit compared to our original expectations because Sue and I toned down our purchases of inventory in the back half of the year to more align with sales. So that's came down a little bit, but you can call that 0.5%.

And then we expect about 0.5% from less promotions or less liquidation sales. That's really that approximate 3% improvement we expect to get this year compared to last year.

Some of that MFO, pretty high confidence level on MFO, operating efficiencies that could move a little bit. But the domestic manufacturing is all shut down and wrapped up. A lot of that is pretty much baked in at this point, Todd.

Got it, thanks. And just one quick follow-up. You said 5 to 10 stores being opened next year. Is that combined between the two channels or is that in each channel, full price and outlets?

Combined.

Combined. Okay, great, thank you.

Thanks Todd.

We'll go to Mark Altschwager with Robert W. Baird.

Good morning, thanks for taking the question. First one's on the competitive environment. The handbag space is looking more promotional than it was a year ago. How is this impacting your view of the white space opportunity from a price point perspective?

Mark, thanks for the question. I think we're definitely hearing, obviously in the handbag space, that a lot of our competitors are beginning to look at promotion and trying to pull back. We definitely are looking at that white space and looking at the promotional impact.

But we still believe there's really opportunity, particularly with the introduction of like our new Wildwood leather collection. You can see that we're filling in those price points and bringing some price points down. As well as the introduction of these new fabrics, we think really fit in this $100 to $200 price range, which we believe is where the big white space is, as opposed to the above $200.

Okay, that's helpful, thank you. And then following up on the indirect channel, lots of puts and takes there with the success with the department stores offset by some of the changes with the specialty accounts. Bigger picture, is there a steady-state revenue level you would anticipate in that channel moving beyond FY16? And then, specifically how have these liquidation sales and the department store expansion in recent quarters impacted the specialty relationships?

Yes, I'll let Rob talk about the relationships a little bit. But with regard to the numbers, we still expect a modest decline in the specialty channel in terms of number of doors. We exited the quarter with about 2,700 doors. It was only slightly down from year-end, which was a pleasant surprise to us, but we still expect some modest decline there.

As far as stabilization, we are looking to add additional doors, especially in the specialty apparel area. We're looking for that to somewhat offset some of that modest decline in the gift channel doors. But as far as stabilization, we haven't seen it yet.

You can see the guidance, obviously. We still expect it to be down in the back half of the year. Obviously we're looking to stabilize that as soon as possible, we just haven't seen it yet, Mark.

And then I'll answer the question about the relationships. First of all, I believe that the relationships between us and our specialty gift partners continues to strengthen. There's a lot of things that we're doing to address their core concerns.

One of the core concerns is that we needed to really work on giving them segmented products so that they could improve their margin, have exclusive product. Sue and the team have done a great job of developing that, and they've been very excited about that.

We saw them begin to market their exclusive navy microfiber, which they had earlier in the spring, which really helped some of our partners turn around their business. The ones that are jumping on the exclusive product are seeing some nice results. That's one thing we've done.

The other thing that they've asked us to do is really pull back on the hyper-promotional discounts. The level of promotional discounts that we've been running as a Company over the last few years are not sustainable for them. It was definitely a big factor in our decision to pull down that promotional activity. We've taken very aggressive steps in the first quarter and are ramping up those efforts as we get to the back half of the year.

So those were two of the major ones that we were focusing on. Obviously as we were liquidating last year and running deep discounts, that did cause frustration on the specialty environment. But they understood that we needed to do that to get our inventories clean, so they endured that.

And then we're also working with them as we open up these department stores to make our lines in both channels more exclusive so that they're not competing head to head. We believe both can operate effectively. A lot of the pressure that the specialty store has seen recently is the same pressure that we've seen in our full-line stores, and that's really due to the need for new product innovation.

As we begin to get that into the stores, we're beginning to see some stabilization, particularly for the accounts that are much more aggressive in going after the new product. The ones that are not moving as aggressively on the new product are not recovering as well.

Thanks for all that additional color and best of luck.

Thank you.

(Operator Instructions)

And we'll go to Eric Beder with Wunderlich.

Good morning. Could you talk a little bit about, in terms of the department stores, what kind of product offerings you want to give them in terms of the leather product? And where do you see that channel becoming more or less important going forward?

Eric, it's Sue, I'll take the question. We do see department stores playing an important role, particularly as we introduce the new innovation of leather, as well as our brand new Poly Twill and Preppy Poly. We have completed some of our markets and we are, in fact, seeing replacements take place. We do believe that they are an important structure in order to change the perception of the brand and to make sure that the new innovation is in front of the consumer that is walking in that door.

Are you seeing any cannibalization in the malls where you have department stores that have taken on the product and your own stores? Or is it a different customer base looking at these?

We have not seen cannibalization in our own stores. As a matter of fact, in talking to our department stores, it works the same way.

When we open a store where we already have a department store distribution, that they don't see any cannibalization either. We definitely believe that there's synergy between our own stores and the department stores.

Okay. And on the incremental $8 million marketing spend, where are the buckets going to go in terms of where you're going to put the media spend in terms of online, magazines and other areas? How should we think about that?

Yes, primarily we're focused on digital first and foremost, so that's where the majority of that spend is going to go. Obviously we have Theresa joining us in a few weeks, and she may change this a little bit, but digital first and foremost.

Also increasing spend in terms of social media and PR pretty significantly this year. That hasn't been a focus for us over the years. We're definitely looking to increase that, including potential ambassadors, which we obviously have one already.

And then print as well. You'll see us in a lot of different magazines. We mentioned on the call a few of them that we were in, but we're in fashion magazines such as Vogue and Teen Vogue, et cetera. We're in Better Homes and Gardens, Shape, Real Simple, Seventeen, et cetera. You'll see us in print throughout the year as well.

Great, thank you. And good luck for the rest of the year.

Thanks, Eric.

Thank you.

We'll go to Neely Tamminga with Piper Jaffray.

Great, good morning. Neely Tamminga. Rob, can we step back a little bit on this and almost arc back to our analyst event? Could you help us think through this?

So the Company built itself into like a $0.5 billion brand with basically great design, authenticity and word of mouth. And over the last three years, and I understand you're coming in here batting cleanup a little bit, right? But over the last three years you're basically heading into three years of revenue declines.

So we hear from you, you want to talk about awareness and raising awareness. Could you help us ground that assessment around what some of the key metrics are around unaided awareness or aided awareness or how your new to file is tracking with some of these newer product initiatives that go outside the core? We're trying to better fully understand the progress on raising awareness right now. Thanks.

Great question, thank you. First of all, when you think about this whole issue of awareness, when we talk about awareness, there's two pieces of it. One is just brand awareness, as you say. Do they know Vera Bradley, which is one piece of it.

But as important, it's what does Vera Bradley stand for? What we've found in our latest research is that the consumer still equates Vera Bradley with cotton quilted patterned bags. And we definitely know from a fashion standpoint that it doesn't have the same resonancy that it did before. So we need to expand the consumer's awareness of what Vera Bradley represents.

What we're finding in these focus groups, and we held focus groups in three major cities in the US. And what we found is as we showed them the new product, it really resonated with them, but they weren't aware that it was there.

They had a notion that Vera Bradley was good when they had a backpack or good when they bought a duffel. But once they bought their cotton quilted one, they didn't need another cotton quilted one. But when they began to see all these new products, they were excited and much more apt to come back and visit the store and make an additional purchase.

So it's really building awareness around a fuller product offering, that we have more fabrication, more solids, more styles that can fit into her current life. So when we talk about awareness, it's a little bit deeper than just brand awareness, but what they're aware of.

We are finding that the new consumers coming into our file are reacting to the new product. We are finding that the new product is bringing in a new consumer, that more of their purchase or more of their cart is focused on the new product and the core product. So we are seeing that resonance.

Our overall brand awareness is still high in terms of people have heard of Vera Bradley except when you go to the West Coast. But they don't understand what we offer, and that's what we have to build is the awareness of our offering.

Thank you. And then could you bridge that then with the strategy at outlet? So the success that I think we're hearing around the made-for-outlet strategy, are those MFO products primarily in what you consider the traditional more quilted pattern? Or does it also encompass the newness that you've been bringing out there to broaden the awareness of the Vera Bradley spectrum? Help us now arc that to the MFO strategy. Thanks.

Yes, absolutely. In terms of MFO, we always expect MFO to follow but not be concurrent with, our full-line strategy. So what does that mean?

Currently the vast majority of the MFO product that is in our outlet is in the core cotton quilted program. We have begun to introduce microfiber into the outlet channel, which is doing exceptionally well and out-selling the core cotton. There's definitely a need for newness in our factory channel also.

And we are also beginning the development of these other fabrications into our MFO strategy. But we want to make sure that whatever we take into our MFO strategy is highly differentiated from our full-price offering. Because we obviously want to make sure that we're maintaining a very strong fashion presence in our full-line stores and a reason to buy full price. You will begin to see these fabrics over the next (technical difficulty) as some of them begin to trail into our outlet.

Great, thank you.

We'll go to Steve Marotta with CL King & Associates.

Good morning, everyone, thank you for all the detail on the call. I just have one question. As it pertains specifically to your marketing plans between now and the holiday season, so that would be obviously summer, back to school, and holiday, what specifically are you doing to endeavor to increase traffic to the stores? Is there anything that you can talk about, direct mailers? Anything to drive additional traffic to your Company-owned stores? Thank you.

Thank you, Steve. First of all, the total campaign as we look at the $8 million, we definitely are continuing to invest that as we go through the third and fourth quarters. Obviously in the third quarter has a very strong back to school focus.

But it is a combination of a lot of digital advertisement, a lot of working with blogs in the social media world, as well as looking at PR opportunities. Because what we believe we really need to do is get people talking about Vera Bradley again, we think is the most important thing.

Then we also are working on a localized basis. We've been testing some local mall-based marketing in Dallas, which we're starting to get some good initial results on in terms of really working locally with the malls to drive consumers into our stores. I would say there's really a two-part strategy, but the vast majority of it is built upon building brand awareness and getting consumers to talk about us again.

Okay, thank you.

Thank you.

We'll go to Dana Telsey with Telsey Advisory Group.

Good morning, everyone. As you think about some of the marketing that you have done, the I Am campaign and the testing phase, and you mentioned that execution fell short of expectations, what changed from what you had expected at the beginning, the difference between the testing and the execution?

And lastly, when you're talking about the indirect retailers, the specialty retailers, what are they seeing in terms -- what feedback are they giving you? And with their order reductions, how do you see that progressing throughout the year? Thank you.

Thank you Dana. First of all, let me talk about I Am, just to make sure that we're really clear. What happened is that we had the I Am campaign set to launch for back to school.

Because we had received such good feedback, Angel had tried to work with the agency to scramble and move that all the way up to Mother's Day. In that scrambling, he worked directly with the agency and placed advertising in national magazines that nobody else had seen. Our agency just was not able to execute it that quickly, and so we put advertising out in the market that did not truly align with I Am.

I would not really say that the Mother's Day campaign was the I Am campaign. That still really focused on back to school. It was really a matter of rushing and having the person who was steering that not have the same creative focus as we really had envisioned for the brand.

But obviously that's changed. We have a new CMO in place who we feel is definitely aligned with the creative execution. We feel much better about how we'll be able to execute that going forward.

So that's really the I Am campaign. But you'll begin to see the real flavor of I Am as you get into back to school in July, going into fall in September. That's really where that focus is.

And then, Dana, with regards to the indirect segment, in total anyway, which we gave guidance on, of being down in the high single-digits to low teens, keep in mind we had about $3.7 million of revenue that went into Q2 this year, which was in Q1 last year. So you can tell that number, that guidance number for Q2, is obviously much better than what we had in Q1. And then as you get into Q3 and Q4 in the back half of the year, we still expect, obviously, it to be similar to what the Q2 guidance is as you look at the full-year guidance for the indirect segment.

And what we're hearing from that channel, and it's been interesting because we've been spending a lot of time, Sue, myself, Barb, everybody, have been out with them, listening to them. And we keep asking them what are their customers saying? What do they want us to do?

And what they say overwhelmingly is that you have to continue to evolve the product. That what happened with your brand is that for too long you did not evolve the product, and then you started to use hyper promotions to drive business.

So we are addressing both of those things very aggressively. They're very excited about the new product direction. They continue to say their customers are commenting positively, but there's a lack of awareness out there. And they're saying it's going to take time to build that awareness, so keep pursuing the path that you're on.

And they keep pushing us to move faster to reduce the promotional activity, the hyper-promotional activity, which is exactly what we're doing. So we believe that we're on the right path, but it is taking some time to do the fruits of that strategic implementation.

Thank you very much.

Thank you Dana.

This does conclude today's question-and-answer session. I will now turn it back to you for any additional or closing remarks.

Thank you. I continue to be extremely proud of the progress that our team has made over the past year. We are transforming our product assortments, modernizing our stores, evolving our outlet stores to a factory outlet model, improving our online shopping experience, adding important department store relationships and ramping up our marketing efforts.

It will take time for these efforts to pay off. But I believe all of these are the right steps to attract new customers to our brand and for the future of the business.

Thank you for joining us today and for your interest, time, and questions. We look forward to speaking to you on our second-quarter call in September.

This does conclude today's conference. Thank you for your participation.