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Phillips-Van Heusen Corporation (NYSE:PVH)

Q3 2012 Earnings Call

November 28, 2012, 09:00 am ET

Executives

Manny Chirico - Chairman and CEO

Mike Shaffer, EVP and COO and CFO

Dana Perlman - Treasurer and Head of IR

Ken Duane - CEO, Wholesale Apparel

Analysts

David Glick - Buckingham Research

Christian Buss - Credit Suisse

Omar Saad - ISI Group

Erinn Murphy - Piper Jaffray

Diana Katz - Lazard Capital Markets

Dave Weiner - Deutsche Bank

Operator

Good morning everyone and welcome to the PVH Corp. Third Quarter 2012 Earnings Conference Call. This webcast and conference call is being recorded on behalf of PVH Corp. and consists of copyrighted material. It may not be recorded, rebroadcast or otherwise used without PVH’s expressed written permission. Your participation in the question-and-answer session constitutes your consent on having any comments or statements you make appear on any transcript or rebroadcast of this call.

The information made available on this webcast and conference call contains forward-looking statements that reflect PVH’s view as of November 27, 2012 of future events and financial performance. These statements are subject to risks and uncertainties indicated in the company’s SEC filings and the Safe Harbor statement included in the press release that is the subject of this webcast and call. These risks and uncertainties include the company’s right to change its strategies, objectives, expectations and intentions and its need to use significant cash flow to service its debt obligations.

Therefore, the company’s future results of operations could differ materially from historical results or current expectations. The company does not undertake any obligation to update publicly any forward-looking statements including without limitation any estimate regarding revenue or earnings. The information made available also includes certain non-GAAP financial measures as defined under SEC rules. Reconciliation of these measures are included in the third quarter earnings release which can be found on the www.pvh.com and the company's current report on Form 8-K furnished to the SEC in connection with that release.

At this time I'm pleased to turn the conference over to Mr. Manny Chirico, Chairman and CEO of PVH Corp. and Mr. Mike Shaffer, Executive Vice President and Chief Operations and Financial Officer. Please go ahead, gentlemen

Manny Chirico

Thank you, Kelly. Good morning everyone and thank you for joining us. Joining me on the call as Kelly says Mike Shaffer, our Chief Financial Officer; Dana Perlman, our Treasurer and Head of Investor Relations and Ken Duane, who runs our wholesale businesses in North America.

I will start by saying, we are very pleased with our results for the quarter which we updated due to the Warnaco acquisition three times during the third quarter. We beat the top end of our guidance by $0.04, and given the momentum in the business, we also increased our full year 2012 earnings guidance to $6.37 to $6.38 a share.

Let me get into the businesses. I will start with the Tommy Hilfiger business, which continued its strong performance during the quarter. We posted a 1% revenue increase and a 16% increase in operating income. When you take out the foreign currency headwinds, our operating performance was even stronger. On a constant currency basis, revenues were up about 6% and operating income for the quarter was up over 25%.

Moving to the international businesses of Tommy; internationally revenues were up 4% in local currencies, our retail comps in Europe posted a 14% increase, while European wholesale sales were flat for the quarter. Geographically in Europe we continue to see strong growth in Central and Northern Europe with particular strength in France, Germany and Turkey, partially offset by softness in Southern Europe in the markets of Spain and Italy.

Our business in Japan continues to struggle with negative comps and operating income declined, as we reposition the brand to a more premium position. We expect these trends in Japan to continue into the fourth quarter and to the first half of next year, as this market is being repositioned upwards from premium position because it’s the gateway to Asia.

Moving to North America, we posted an 8% revenue increase for the quarter, driven by a 9% comp store increase in our retail business and mid-single digit growth in our wholesale businesses. We continue to see momentum in the North American business and strongly believe that the significant investments we are making in product, in our stores, in our shop presentations and in our marketing programs are paying dividends for us.

We have seen average unit retails increase about 10% over the last 12 months at both wholesale and retail. Most importantly in North America for the nine months of 2012, we have seen sales increase 10% and operating income grow by over 50%, which we believe quantifiably demonstrates that these investments we are making are paying off.

Moving to our Calvin Klein business; we continue to exceed our financial guidance here and post strong results. Total revenues in the third quarter for the combined Calvin Klein businesses were up 6%, while operating income was up 7% despite overall softness in the global jeans and women’s underwear business. These increases that we have experienced were driven by our Calvin Klein North America retail and wholesale businesses, which posted 13% revenue increase.

The Calvin Klein brand posted revenue increases in all geographic regions with the exception of Europe. Specifically by region, North American sales were up 3% with all product categories posting strong results with the exception of jeans and women’s underwear which were down double-digits. Asia sales were up 13% driven by double-digit growth in China, Honk Kong and India partially offset by weak sales in Korea.

Latin America and South America sales were up about 10%, driven by Brazil and Mexico. Europe, we see the continuation of sloth business for Calvin Klein, with business down about 8% related to the poor performance of the Warnaco’s power and underwear business.

In our licensing segment, royalty revenues were flat on a constant currency basis. This increased was driven by strong performance globally in women sportswear, dresses, footwear and handbags, who always post to double digit increases. This positive performance was negatively impacted by 8% decline in Warnaco’s global Calvin Klein sales.

Let me put some color on each of the businesses; I will start with jeans and underwear. As I mentioned the overall business was down about 8% on a constant currency basis in the third quarter. The reduction was due to continue weak performance in North America and Europe jeans and women’s underwear business. Strong sales in Asia and South America were more than offset by the poor performance in North America and Europe.

Moving to fragrance; our fragrance businesses continue its strong performance with our royalties up about 4% on a constant currency basis in the quarter. We continue to see strong performance from our Euphoria, CK1 and Beauty franchises. We are very well positions in this category for the holiday selling season, as Korea has made a major global marketing campaign investment centered around our largest fragrance Euphoria which should help to maintain the momentum in this business in the all important holiday selling season.

Our women’s business in Calvin Klein in North America both women’s apparel and footwear businesses were very strong in the quarter. Our royalty revenues with our licensees G3 and Jilmara for women’s were up about 10% for the quarter.

On the apparel side, this growth is being fueled by strong selling of women’s sportswear, women’s performance, dresses and suits. In addition, our handbag and accessory business continues its strong performance. G3 has seen excellent sell through at all department store accounts. We are targeting double-digit growth for this product category in 2012.

Our CK Bridge business in Asia continues to grow dramatically posting a 7% increase in revenues for the quarter. We expect this business to grow mid-teens for the year. The growth is being driven by the China, Hong Kong and India markets where we are experiencing significant door expansion and comp store sales growth.

For 2012 as we previously discussed our CK royalty revenues are being planned flat for the second half of the year due to the uncertainty in Europe and weakness that we see in our North American and European jeans business.

In order to take the financial risk out of our guidance, we are currently projecting all of the European jeans and apparel businesses that Warnaco operates at contractual guaranteed minimums of fiscal 2012. As such our Calvin Klein European royalties are being planned down about 10% for the year. Overall, we are planning total royalty revenues on a constant currency basis to grow about 2% for the year.

Moving to our Heritage business, excluding the impact of the exited businesses, ongoing revenues for the Heritage businesses increased 3% in the quarter. Comp store sales in the quarter in the Heritage business were up or flat while our ongoing wholesale businesses posted a 4% sales increase due principally to strong royalty in the IZOD and Van Heusen sportswear businesses.

Operating income increased 4% to $47 million driven by strong performance in our wholesale dress and sportswear businesses partially offset by continued weakness in our retail businesses particularly the Bass business.

Clearly, our Heritage business is in the midst of a major turnaround. We are very confident and feel we are very well positioned in this business. Our fall order book is on plan, inventory levels are in line with our retail sales plan, AURs are currently up about 5%, product costs are decreasing between 5% to 7% and our in-store presentations are being enhanced and expanded with key customers.

The IZOD J. C. Penney store openings are performing and doing very well for the last [12] months, all of this gives us a high degree of confidence that we will see a dramatic improvement in the business beginning in the fourth quarter of this year.

Let me talk a little bit about fourth quarter trends that we are seeing in the business. I will start with our international Tommy business. At Tommy retail in Europe, our comps continue to post low-teen comp store increases against about 5% to 6% comp store plan. Tommy wholesale which represents about 70% of our business continued a strong momentum. We are seeing no indication of slowdown or cancellations with any of our European customers and feel very good about our European sell through season to-date. The fall season is off to a strong start; given our strong European sales trends we are continuing to grow our market share in all key countries.

Looking at the spring 2013, our order book is complete and would indicate a wholesale sales increase for the first half of 2013 of between 4% to 5%. In the US wholesale businesses both Calvin Klein and the Tommy Hilfiger business continued to perform well ahead of plan. We continue to see increases on our out the door retails, our margins at retail are very strong and we feel very confident about how this business is moving forward.

As I mentioned, we are seeing strong business in the Heritage portion of our wholesale business as well. We have very strong sell through to November and we experience AUR increases particularly in our sportswear businesses.

Moving to our North American retail businesses, November comps which were impacted by the Hurricane Sandy, our comps for Calvin Klein were relatively flat for November. The Tommy Hilfiger business posted a 4% increase in comps and our Heritage businesses are running down low single-digits.

Business in the first half of November was significantly impacted by the storm which we estimate impacted November comps by between 250 basis points to 300 basis points for the month of November.

We continue to feel confident about this business and for the second half of November we have seen our retail business come back on plan and get back on the trends that we saw in the third quarter. As we look out into the fourth quarter, the holiday season is off to a good start.

We are highly confident that we will deliver our fourth quarter plan which projects ongoing revenues to grow 7% on a constant currency basis and earnings per share increase over 25% to about a $1.49 per share this year. So we feel good about we are well positioned and with that I am going to turn it over to Mike to quantify some of these results.

Mike Shaffer

Thanks Manny. The comments I am going to make are based on non-GAAP results and are reconciled in our earnings release. We are very happy with third quarter results. For the third quarter, we exceeded our revenue guidance and delivered earnings per share of $2.34 which was $0.04 above the top end of our guidance and 24% greater than the prior year. $0.03 of the $0.04 EPS increase over our previous guidance was due to favorable timing of certain discreet tax items that were planned in the fourth quarter.

Our total revenues exclude currency translation and discontinued businesses were up 4% to the prior year. Our Tommy Hilfiger revenues which were ahead of guidance were strong in both Europe and North America. On the cost currency basis Tommy Hilfiger revenues were up 6%. Our Calvin Klein revenues for the quarter were plus 6% to last year and also better than guidance.

Overall, third quarter operating margins increased 150 basis points over the prior year driven by 260 basis point increase in gross margin.

Moving our guidance for 2012, we have raised our full year EPS guidance to range of $6.37 to $6.38 or an increase of 18% to 19% over the prior year. We raise the top end of our full year earnings per share guidance for $0.04 third quarter a bit, less the $0.03 that was attributable to the timing of taxes between the third quarter and fourth quarter.

Revenue for the year is planned to be up 6% excluding the impact of foreign exchange in our discontinued businesses. Total Tommy Hilfiger revenues are planned to be at 8% on the cost currency basis with both Tommy Hilfiger North America and Tommy Hilfiger International increasing about 8% on a cost currency basis.

Calvin Klein revenues are planned to increase 7%, well our ongoing Heritage businesses are planning revenues up 1% excluding the impact of Timberland and IZOD women business.

Gross margins for the year are planned up about a 170 basis points with expenses for the year planned up a 100 basis points due in large part to an increase in pension expense.

Impacting our gross margin and expense in 2012 is our mix of business as a result of faster growth and our higher gross margin and higher expense on the Hilfiger and Calvin Klein businesses. Operating margins for 2012 are planned to increase by about 70 basis points over 2011. Interest expenses is planned at about $115 million, reflecting reductions to the prior year as a result of debt repayments. Our tax rate for the year climbed to 23.5% and reflects the continued benefit of additional foreign earnings which attest to the lower rate than domestic earnings.

For the fourth quarter of 2012, earnings per shares is planned at $1.48 and $1.49 or an increase of about 25% to 26% over the prior year. We are planning our revenues to increase 7% to 8% over the prior year excluding the impact of foreign exchange in (inaudible) businesses.

Our gross margins for the fourth quarter will be up about 300 basis points, with all businesses planned to show gross margin improvements due to higher average unit retail selling prices combined with four product costs decreases of about 5% to 7%. Overall operating margins for the fourth quarter are planned up about 200 basis points, influenced by a mix of business and gross margin improvement.

Our tax rate for the fourth quarter is planned to 22% and we are continuing to project term loan repayments for the full year of 2012 of about 300 million, which would bring our term loan repayments since the date of the Tommy acquisition to about $1 billion. And with that we will open it up to questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) We will go first to David Glick with Buckingham Research.

David Glick - Buckingham Research

Manny I was wondering if you can give us a little more color on the performance of the jeans and underwear business both domestically and internationally; and whether your view on that has changed since you announced the acquisition. And how you look at the business progressing next year? Is it kind of a repositioning year and when we can start to really see the benefits of your involvement in that business? Thanks.

Manny Chirico

On the jeans business I think Warnaco has been very transparent about the challenges in that business particularly in Europe and some of the difficulties that they have worked through in North America; and I think a number of the initiatives that they have put in place really will start to benefit next year, particularly second half of the year. Focus really on product enhancements of the regional design, the centralized design focus that they are bringing to bear. It seems to be well received in market from our diligence and sitting with a number of the retail accounts talking about business, I think they are being planned up in some of the major retailers for spring and we think that momentum should only accelerate as we go into fall here in North America.

So very positive about I think how this business will start to progress beginning in 2013, and really into 2014 next year. So really no change from how we viewed it here in North America. Also similar to what Warnaco; so I think Europe will be a slower turnaround. I think there the whole business needs to be repositioned. They were in the process of doing that, we will do that again as we integrate them on to our European platform under the Tommy Hilfiger leadership management team.

Fred Gehring will really take over full responsibility for that. And that will go through a transition and that will be a transition year, where we will probably see sales go down slightly further in 2013 as we repositioned the brand for profitability and for profitable growth, really positioning it well for 2014.

I think all of that is being captured in the initial callout we gave about accretion in 2013, assuming that deal would have closed on the first day of fiscal year. As we said we are still very comfortable with the $0.35 accretion that we talked about a month ago. So really no change except may be some validation of what we saw in diligence as we’ve gotten more involved. Just a continuation of that, though we really see great opportunity in the jeans business both domestically and internationally.

David Glick - Buckingham Research

On the Bridge business in Calvin Klein, you commented on the strength in Asia, does the integration of the Warnaco business change your thinking on when your management team can launch that business in Europe?

Manny Chirico

I think that’s all under review right now. As you can imagine the plan was to really bring that out 2013, but now with the taking on of the jeans business I think we are really just reevaluating that whole timing, and if that make sense it is better to make a grand launch together repositioning of the brand. We will make that decision in the next 30 to 45 days. So the team is really working on that looking at it and we will see how that comes together.

David Glick - Buckingham Research

Okay, last question on Cramer last night you were pretty positive about the North American consumer. Just wonder if you can give us some perspective on kind of what you’ve seen in this holiday season so far and obviously a lot of disruptions, distractions, what gives you the confidence that it’s going to continue to be a strong holiday season?

Manny Chirico

I guess the best confidence we have is the last two weeks of business both the wholesale and retail. Coming to everything sitting here and talk about the fiscal cliff and we can talk about of the economic issues, but really and particularly at wholesale, we have just seen a lot of momentum in our big sportswear businesses, our sales through on AUR and how that works on the ground. (inaudible) that really should benefit allowances at the end of the year. We are really looking for a dramatic improvement; all brands are very positive, and as I said the AUR is up pretty dramatically.

David Glick - Buckingham Research

And on the seasonal businesses you are saying some benefit relative to last year where it was a challenge?

Manny Chirico

When you say seasonal you are talking cold weather for all.

David Glick - Buckingham Research

Cold weather, yes.

Manny Chirico

We have a small outwear business relative to our size that we are, and we have only have the big sweater business, and the sweater business has been good, but I wouldn’t say great yet, and what we are really seeing is the basic sportswear businesses that the brands really represent driving it across the board. So it’s so much noise in holiday season with the extra weekend at the end with the two extra days between Thanksgiving and Christmas, I think personally if you are (inaudible) I think its going to come, I think its going to come later, I think its just the nature of how the calendar is laying out and I am sure, we are going to have a lull in the beginning of December, where everybody is going to panic for a moment. But I just feel like that is it will come back strong as we go into the last two weeks before the holiday.

Operator

We will go next to Christian Buss with Credit Suisse.

Christian Buss - Credit Suisse

Yeah, I was wondering if you could talk a bit about the marked down dollar benefit that you got year-over-year and how you are thinking about that as it plays out for the balance of the year?

Manny Chirico

I guess we are getting a marked down benefit particularly on the Heritage side. I think last year well that hit us by far the hardest was in the fourth quarter. I think the fourth quarter has the ability to really see in Heritage business 400 plus basis points improvement in gross margin, probably 400 basis points to 500 basis points improvement in gross margin driven a little bit by somewhat by cost declines but significantly be driven by out the door retail increases that we are really starting to experience as we go into December.

Christian Buss - Credit Suisse

That's helpful. And could you talk a bit about what you are seeing as you start to place your buys for spring 2013 from the sourcing environment?

Manny Chirico

Yeah, I think it’s consistent to what we said about three months ago. We are looking for costs down about 4% to 6% for spring 2013 and that's been both put to bed and is done.

Operator

We will hear now from Omar Saad with ISI Group.

Omar Saad - ISI Group

I wanted to ask you, you mentioned that the efforts in Japan for Tommy to kind of reposition in a more upscale premium positioning, obviously, the brand’s had a lot of success with those efforts in Europe. It seems like it’s also still happening in North America. Can you talk about on the Calvin Klein side with the impending acquisition of Warnaco and a more holistic control over the brand, how do you think about the opportunity to bring that brand up market a little bit and make it more of a premium brand globally?

Manny Chirico

Well, look outside of North America, the brand is in premium position. In Asia, our out the door retails and sportswear is over a $100. So we are positioned probably just slightly higher than Tommy is positioned in our sportswear businesses throughout Asia and South America. So I think that the positioning of Calvin Klein brand is terrific there. The Calvin Klein brand is actually growing in Japan. It’s not as bigger business as we like but it continues to grow in Japan. It’s a challenged market. So we don't have a repositioning from a brand point of view to do it all with Calvin Klein in Asia or Latin America. The real repositioning happened from both a process operations point of view as well as the brand really in apparel taking its rightful place in Europe. So that's only I just disagree with the premise of the question, the brand is growing strongly in Asia, up double-digits, its premium positioned, I wouldn't want to take it any higher, I'm not looking to, we don't view Calvin as a luxury brand, we view it as a premium status brand and I think that position works really well for us.

Omar Saad - ISI Group

And in terms of how are you looking at, I know you are going to kind of probably do some things to manage it more of a profitability maybe slow some of the square footage growth, investments that need to be made in that business, you know I know its all kind of embedded in the outlook that you provided but is this a multi-year kind of investment process, accelerated investment process and scaling back on the square footage growth for Calvin Klein?

Manny Chirico

I think to be determined, we are very comfortable with the guidance we gave that talked about the accretion growing from $0.35 to $1 a share beyond that the opportunities to do things that are outside the plan and accelerate the growth beyond that plan that’s really what we need. We don’t own the business yet directly we are working very closely with want to go about planning the integration particularly at back office and looking at things with strategic point of view, but it’s just too early to comment. We only announce the deal a month ago. So I think it’s too early to really comment exactly what kind of growth we see year-by-year but give us the time as we get into the first quarter of 2013, we will put some more flesh on that.

Omar Saad - ISI Group

Then any quick comments on the accessories opportunity across your brand, it’s obviously bit of big theme in the marketplace?

Manny Chirico

Yeah, I would start by saying both Tommy and Calvin are global designer lifestyle brands. They are not accessory brands by their nature. They both have the ability to have a significant accessory component. Calvin Klein is significantly more developed today than the Tommy business has developed, and we are seeing strong growth in basically Asia, we have seen strong growth in North America with the accessory business we think it’s a significant opportunity in Europe given the design esthetic of Calvin Klein and given the design capability we have in the Calvin Klein design studio which we have relatively been fully utilizing but now we have control of the brand particularly in Europe we think it’s a real opportunity for us to grow that accessory business both in Asia and Europe pretty dramatically. So it will be a key component in North America.

We are looking at free standing Calvin Klein accessories stores both have the first (inaudible) that we have opened have been real success stories for us. So we think what’s great about the accessory business is one, it’s very profitable and two just by the nature of the product to presentation, where Calvin Klein sits it’s significantly enhancing.

So the opening of stores and regular price moles and street locations that they really can be profitable, at the same time I think just lifts the level of the brand and it really coordinates with all of our marketing efforts. So a scenario of growth, I think you will see us really going after 2013 and beyond.

Operator

We will go now to Evren Kopelman with Wells Fargo.

Unidentified Analyst

Hey, it’s (inaudible) for Evren. I was just hoping if you guys could please sort of elaborate on the Tommy Hilfiger comps in both Europe and North America during Q3, what's specifically driving these games in each of the regions, I know you mentioned AUR increases but is it a mix shift or price increases AURs and then may be traffic and conversion?

Manny Chirico

Okay, so in the third quarter Tommy was up, I think 9%, it was not (inaudible) but it was everything. We saw higher AURs, we saw better conversion and traffic was up low single-digits for the third quarter. I think the key area of benefit that I think we are getting first and foremost is product, the product has been enhanced, its been invested in and the consumers are willing to pay for that product, actual price, full price and first price for us in our retail stores. So we are seeing it across the board.

In Europe I think there's two things going on, just the strength of the brand continues. We continue to be better retailers globally and continue to just maximize that business. We are significantly under penetrated as a brand in the outlet venue throughout Europe; we are just starting to open some of those stores and working with the brand management. We are not going to overdo it, but we have such a low penetration in that market that as we go into it, given the brand’s strength, we will really perform exceedingly well and that's part of the benefit as well.

But we are seeing strong sales increases in our regular price stores and in our outlet stores throughout Europe. So it’s a combination of all those things and geographically in Europe I would just say I mentioned it in total, but our retail stores tend to be much more central more than European focused. We don't have that many stores in Italy and almost no stores in Spain. So I think over time as those economies come back, those are markets that we believe have a retail opportunity but right now given the uncertainty there its not an area where we want to invest and not having that exposure I think really shields us from some of the more difficult retail markets throughout Europe. So I think we are benefiting from that as well.

Unidentified Analyst

Okay, that's helpful and then maybe kind of in conjunction with that how are you approaching the marketing for the holiday season, is it stepped up year-over-year and what sort of differences are you seeing.

Manny Chirico

I think that the strategy is more or less the same. We continue to really invest behind the (inaudible) Hilfiger’s campaign at all levels, and I think that investment has clearly paid off. We are spending a larger and larger percentage of our marketing dollars digitally and going to that venue; trying to focus both for Calvin and Tommy on the under consumer and bringing that consumer into the ranks.

I think its really helped the whole on-the-channel strategy both North America and Europe, a combination of all bricks and mortars, our wholesale distribution, our own internet that we sell on and then selling through some of our key retailers where we've seen dramatic growth at Macy’s and some of our key retailers here with Calvin and Tommy brand online has really just enhanced the performance of the brands overall.

So as we've owned the brand, as we've really focused on both Calvin and Tommy, its become much more of a holistic marketing approach and really trying to connect with the consumer in the hot zone when they are making the retail decisions either in store or online.

Unidentified Analyst

And one more question kind of bringing it back to North America, looking at Black Friday weekend, you mentioned the wholesale was very strong but how about the environment in your own retail stores, can you talk to traffic trends, how are the promos year-over-year or are things more aggressive in this channel.

Manny Chirico

The two week period second half of November was right on plan. I would say the outlet in volume for the three day period of the weekend when traffic was down compared to prior years. I think the noise the big box retail as we are doing from an advertising positioning point of view, the noise that was also going on even at the regular mall where there was much more earlier openings we've kind of owned that. The outlet environment three years ago, kind of owned that timeframe from 9 o'clock on thanksgiving night to 5 o'clock in the morning. We were almost the only game in town and it really just started to till we really benefited from that.

Competition during that period of time was not as much more intense Wal-Mart opened at 9’0 Clock and (inaudible) was opened early, everyone really was - Macy’s opened much earlier. So every retailer was much opened by midnight that we were competing with everyone. So we saw traffic down the three day period, but we also saw retail comps with only two days where it really bounced back just strongly Monday and Tuesday of this week back on trend.

So I think with the moment in time a lot of noise, lot of advertising going on, people looking for electronics and other things and not necessary an outlet venue. So I think that’s what happened on Black Friday.

Operator

We will go now to Erinn Murphy with Piper Jaffray.

Erinn Murphy - Piper Jaffray

Manny I was hoping you could just may be elaborate a little bit more on Japan. Do you think about that market and could you pass out may be how much of that negative comp is high just to general consumer (inaudible) in that market overall versus the change of these nature reposition of the Tommy brand. And then with respect to the repositioning how are you communicating those changes to the consumer in that market?

Manny Chirico

I think to be totally transparent, it’s very hard to quantify that. I think that Japan is clearly not a growth market, but by the same token I don’t think on a relative basis that retail is under dramatically underperforming there. So I think we have to recognize the vast majority of the downturn that we are seeing there is self inflicted from a brand positioning point of view and what we are doing.

So I think from that point of view we have clearly tried to step off marketing in the Japanese market, we have opened two flagship stores to really make a statement about the brand and try to really don't speak to the brand and lift it up, and we really invested behind the products. So it is a dramatic change that the consumer’s seen over 12 months period, its going take some time for them to accept it and understand it. I think its going to be a slow grind which will continue.

The good news is that it’s really at a low point that will be able to balance (inaudible), but still getting where we really want it to be this is a three, four year process of repositioning a brand similar to what's been done here in North America over the last six years and we are really seeing the fruits of that the last few years. I think Japan will be a similar situation, but it really needs to be done Tokyo as the fashion capital of Asia, and you can't be misaligned as a brand in Japan and then really want to be big in China, India, and Korea, where we are experiencing double digit growth across the broad.

So I think its really important from the brand positioning to be appropriately positioned there, and we are making those investments and fortunately that will absorb the hit that we are taking because of the strong performance here in North America and Europe.

Erinn Murphy - Piper Jaffray

Okay, that's helpful. And just a quick clarification on some of the comments you made earlier on southern Europe and particular still obviously on the performing of the northern European side, are you seeing any wasting of trend there just as we anniversaried a very significant year in southern Europe as very tough trends?

Manny Chirico

Yeah, its down less but its still down. I guess, that's the best way I can describe it. I think it’s bottoming out, its finding its bottom. I think all of those things, but its still there, its still a market that’s very challenged, those two markets.

Erinn Murphy - Piper Jaffray

And as you think about the holiday season in Europe, can you maybe just speak to how you are thinking about the overall promotional environment, anything you’ve changed and how your are looking at the brands in Europe for the holiday?

Manny Chirico

I think as what we've done exceedingly well is manage inventories. So, we are not in a situation and given the strong sell throughs both the wholesale and the comps that we posted throughout the year, we are in a very good inventory position. So I'm not sure what the promotional environment would be overall, it seems to be pretty much the level where it was last year and its different market-by-market but in general, we don't have a big inventory issue that we need to move goods or what else. So, sales trends continue as they are. We just continue to see gross margin improvements as we go forward. So, this is not an environment where we are trying to be a hero, we've kind of said that pretty consistently, we've really bought to the order book and not gone after every last drop of sales. We've really tried to call out some of the bottom level of some of our retail accounts that we've already bought from the credit point of view. So, we've really tried to prune it and be meticulous about how we manage the business and in this environment the uncertainty in Europe causes us to be more risk averse as opposed to be where we were say in 2010 where given the strength and the momentum of the business we were willing to make investments behind inventory that really capture market share. This doesn't seem to be the environment that you want to do that.

Operator

(Operator Instructions) We will go next to Diana Katz with Lazard Capital Markets.

Diana Katz - Lazard Capital Markets

I understand you are not providing guidance today for next year but more on conceptual basis, can you talk about there's anything new within the trajectory of the Tommy business outside of taking in tailored business that we should consider for next year?

Manny Chirico

No not that I can think of, on the Tommy business I think its more of the same, Europe will grow but it will be more conservative. We’ve talked about 4% to 5% kind of top line growth including the tailored business and we've and I guess that's basically that's all I have to say.

Diana Katz - Lazard Capital Markets

And then as Tommy’s business is really benefiting from the growth in [property] trend is there anything you might be changing about this that is for Calvin Klein to capitalize in some of these trends?

Mike Shaffer

No, I think you have to stay true to your brand. 18 months ago when modern and contemporary was more in line we didn't change Tommy to be from red light and blue to black, gray and tan. I think is colors become more important and we try to do color in Calvin appropriate way but again its we will stay true to the brand. In North America and Asia I think Calvin Klein is clearly the leader on the modern and contemporary side in department stores floors and that's a position we need to fill and we can't trend off of that. So in a lot of ways you gain more market share in tougher markets. So in a market like this I think our competitive set is in the modern and contemporary side is really suffering. And we are growing in a traditional property cycle so clearly overall the Calvin Klein business is gaining market share. So that's a positive that we will just take and given our portfolio of brands, a lot of our brands are much more traditional in nature like Tommy, IZOD are really benefiting from the fact that we are in this cycle and we have other brands like Van Heusen and Calvin when modern and contemporaries and dress we find dress up is more in line those brands perform. So I think it’s this balanced approach in staying true to what the brand is.

Diana Katz - Lazard Capital Markets

Okay. And then what’s the plan for the Heritage retail business particularly Bass to kind of turn that around?

Manny Chirico

I think its look I would say that’s a long-term strategy. It’s, we have been disappointed with the volatility of the Bass business keep in mind, it’s a $250 million business represents 3% of our sales and may be 1% of our profits. So, we tend to be so transparent we talk about everything. So there is a number of initiatives going on and hopefully we will start to see some improvements, investment and product which the Heritage of our brand what that stands for that management team is working on it very closely.

Diana Katz - Lazard Capital Markets

Okay. And then finally on the fourth quarter model, it seems gross margins are coming in higher than originally planned for the year, is this purely driven by the Heritage businesses or other areas contributing to out performance? And then similarly SG&A seems to be also becoming in a bit higher, is this primarily its opening larger stores or is there something also with an SG&A?

Manny Chirico

I think Mike will talk about that.

Mike Shaffer

Basically, the gross margins are up about 300 basis points and pretty much as we plan them I don’t believe we have had much change. Heritage is driving that business, are driving those margins up that’s the biggest piece, but all our businesses are seeing gains. The cost decreases were a major factor there. On the expense side, the increase in expense is primarily the pension expense and that’s really is and then of course anything to do with the additional revenues and as you pointed out some square footage growth, but closer and our expenses are in line with our plans in line with the first three quarters of the year.

Manny Chirico

Mix of the business, the SG&A is going to grow as a percentage of sales and gross margins will grow also because Calvin and Tommy and Calvin, Tommy retail businesses in particular are growing faster than everything else in the portfolio. So it’s just a natural act, the key issue is to make sure operating margins overall are growing at the same time.

Operator

We will go next to Dave Weiner with Deutsche Bank.

Dave Weiner - Deutsche Bank

So I was looking for a little bit of color on the sourcing environment as return the corner into next year. I think in the past you have called out kind of as go-forward as we cycle some of the increases from last year, it kind of moderates apparel cost inflation moving forward in 2013, so I know there is a lot of moving parts of that but I was wondering if you can comment on that? And then importantly, whether you think you will be able to continue to offset those with continued AUR increases and whether those will be coming from kind of explicit price increases or more of there some kind of underlying mixed shift in some of your brands that's you know generating that AUR shift? Thanks.

Manny Chirico

I want to make Ken answer the question on sourcing; I will give just specifics for next year.

Ken Duane

So obviously, you have seen a change in 4Q as we move through 4Q. We have seen some of those cost increase, cost decreases come through on the sheet. And as you move into spring 2013, it’s a 4% to 6% decrease I think Manny spoke about it, and then in fall 2013 where its generating about a 4% to 6% decrease again for 2013 for fall. It continues on. Then you will see a leveling off as you move to 2014 because you had a full year of it, annualize the full year.

Manny Chirico

You know David once you get out to 2000 and we've got indication now on fall holidays as Ken said, you know down in that 4% to 5%, 6% who knows that where its going to finalize but depending on the mix of the business as well, but its clearly like more of a continuation of what we saw, and we are seeing in spring is what we expect but when you get into 2014, its going to depend on supply and demand, capacity issues at factories. You know specifically I have always said I think which I quoted is I have always said is when that well is off and when the economy bounces back globally and I don't know when that is going to be, there will be coming a point in time again when demand will outstrip capacity and we shall start to see more of a modern, we will start to see a modeling increase in cost of product. I think its natural and significant global pressure going on, on labor rates around the world. There's you know we've gone to so many different countries that ability to just keep shifting production, I think there is opportunities but not as great as its been in the past. So I think we have to start thinking long-term that we are going to start to see cost increases and that will have to be factored into our business models but again that's 2014 or beyond as we look out.

Dave Weiner - Deutsche Bank

So I guess, that's helpful so I guess given what you said for 2013, the decreases I guess in terms of the plan for AUR, would you continue to expect to raise that level or maybe that will flatten out as well. I guess it will depend on the brand and geography?

Manny Chirico

Again at this point with an environment of 4% to 5% cost declines, I don't think we would be comfortable raising AURs. In fact, we are taking some of those cost increases and investing in product which may in fact raise the AUR but at the same time may not start to raise the gross margin overall. So I think our gross margins will improve because of mix of business year-over-year but right now at this stage we wouldn’t be planning for AUR overall increases on top of the last 18 months of pretty significant AUR increases.

Operator

And gentlemen at this time I would like to turn the conference back to you for closing remarks.

Manny Chirico

Okay, thank you very much. I guess I would thank everyone for their time this morning and we will be speaking to you in March during our fourth quarter earnings call. Have a great holiday season and speak to everyone soon. Take care.

Operator

That concludes today's conference. Thank you all for joining us.

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