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American Eagle Outfitters, Inc. (AEOS)

Q1 2006 Earnings Conference Call

May 16, 2006 9.00AM

Executives:

Judy Mehan, Director of Investor Relations

Jim O’Donnell, Chief Executive Officer

Susan McGalla, President and Chief Merchandising Officer.

Joan Hoxen, Executive Vice President, Chief Financial Officer

Analysts:

Lauren Levitan, SG Cowan & Company

Dana Cohen, Banc of America Securities

Stacey Pack, Prudential Equity Group

Kimberly Greenberger, Citigroup

Brian Tunick, JP Morgan

Jeff Black, Lehman Brothers

Richard Joffey, Steeple Nicholas

Stephanie Wissink, Piper Jaffray

Jennifer Black, Jennifer Black & Associates

Holly Guthrie, Morgan Keegan

Christine Chen, Pacific Growth Equities

Dana Telsey, TAG (the Telsey Advisor Group)

Todd Slater, Lazard Capital Markets

Meredith Kent, UBS Warburg

David Glick, Buckingham Research Group

Presentation

Operator

Good morning. My name is Denis and I will be your conference facilitator today. At this time, I would like to welcome everyone to the American Eagle Outfitters Q1 2006 earnings call. Operator instructions. I will now turn the call over to Ms. Judy Mehan. Please go ahead, ma’am.

Judy Mehan, Director of Investor Relations

Thank you, Denis. Good morning everybody. Thank you for joining us today. With me from management are Jim O’Donnell, CEO, Susan McGalla, President, Chief Merchandising Officer, AE Brand and Joan Hoxen, Executive Vice President, Chief Financial Officer, AE Brand. If you need a copy of our Q4 press release it is available on our website ae.com or please call Aaron at 724-779 6076. Before we begin I need to remind everyone that during this conference call members of management will make certain forward-looking statements based upon information, which represents the company’s current expectations or beliefs. The actual results realized may differ materially from those expectations or beliefs based on risk factors included in our quarterly and annual reports filed with the SEC. Now I’d like to introduce our CEO, Jim O’Donnell.

Jim O’Donnell, Chief Executive Officer

Thank you, Judy. Good morning everyone. I’m pleased with our Q1 performance, which has improved on an outstanding quarter last year. The quarter was driven by successful merchandising and design, as well as the solid execution across our company. I’m proud of our teams and their proven ability to consistently deliver on-trend merchandise within our quality-value equation. Our organization has embraced strong operating disciplines within a flexible framework. We are committed to delivering profitable growth. Our Q1 EPS increased 20% to $0.42, including $0.02 of stock option expense not incurred last year. Our comp increase was 9%, which followed a 27% comp increase last year and marked the ninth consecutive quarter of positive comp store sales, demonstrating consistent operating performance.

We achieved an operating margin of 18.9% while investing in our new growth strategies. So far this year, we’ve made steady progress on our real estate strategies. We are on track to grow square footage by 7% this year through 46 new stores, 68 remodels along with four store closings. In Q1, we opened 11 stores, remodeled 14 and closed four stores. We have recently accelerated our store-remodeling program to capture the strong productivity improvements, with average store profitability increasing 70% in the first year after remodel. In many cases, we are relocating our stores within the mall, expanding store frontage and increasing store size to accommodate incremental business including our new intimate sub-brand, aerie.

Recent new store economics also remain quite positive with sales productivity, with approximately 90% of our mature stores going to first year of operation. Now I’d like to highlight two other growth initiatives, specifically our new brands, aerie by American Eagle and Martin & Osa. Our new intimates sub-brand aerie will launch this fall, supported by a multi-dimensional real estate strategy. We’re up-spanning the intimates presentation in existing stores; new and remodeled stores are opening with more square footage dedicated to intimates. Additionally, we will open three stand-alone aerie locations. We’re also looking forward to launch of our new Martin & Osa concept, a unique, specialty lifestyle brand, targeting 25-40 year olds. Our first four stores will open this fall, in Tysons Corner, Virginia, Fashion Island, in Newport Beach California, NorthPark Center in Dallas and San Francisco Center.

Supporting our future growth, we broke ground in early April on a 540,000 square feet addition to our Ottawa, Kansas distribution center. We’re running ahead of schedule and the project should be completed in early 2007. Our expanded facility will total nearly one million square feet, and support AE’s western stores, aerie, ae.com and Martin & Osa. Lastly, as we prepare for future growth, we continue to strengthen our organization and solidify our leadership structure. Over the last several months, we made a number of key management appointments in the areas of marketing, sourcing and production, finance, real estate and supply chain. In summary, Q1 set a strong, positive tone for what should be another productive year. We will continue to build our brand and pursue strategies to drive growth and shareholder value. Now here’s Susan.

Susan McGalla, President and Chief Merchandising Officer

Thanks, Jim, and good morning everybody. I’m extremely pleased with our performance in Q1, particularly as we anniversaried strong results for last year. Our consistent performance is driven by ongoing improvements to our process and our teams over the past 24 months. In addition, we stay committed to developing the best customer connection in our state. While we are clearly pleased with past results, we have remained absolutely focused on the future. We are vigilant of how maintaining our brand momentum and driving strategic initiatives toward market share gains and leveraging the AE brand through our first sub-brand, aerie by American Eagle.

We entered the quarter with our spring plans sharply focused on making AE the destination for spring break. We delivered an optimistic spring assortment, which reflected newness in emerging trends. Our key items were on target, with both men’s and women’s reflecting new silhouettes in tops and bottoms. We were also pleased with our play on neutrals, whilst staying true to our brand with just the right amount of color. Sales strength was broad based across men’s, women’s and intimates. Our women’s division achieved a high single digit comp. Comps were best in graphic tees, tanks, shorts, capris, jeans, flip-flops and intimates, while women’s skirts, wovens and accessories were below our expectations.

Men’s produced a positive low double digit comp with the strongest results in graphic tees, jeans, shorts, polos, flip-flops and boxers. Within men’s, we continued to see a planned downtrend in woven shirts. Destination AE, that’s our strategy for driving market share, delivered positive results during Q1, contributing to comp performance and the increase in our average unit retail price. This spring, we added incremental styles in targeted categories across men’s and women’s, which offered new fabrications and special design details. These assortments were well received by our customers. It’s important to note that we are absolutely committed to delivering value at every price point. Within destination AE, we are in the initial stages of identifying key market share opportunities, which will evolve and expand over time.

We look forward to the launch of aerie by American Eagle this fall, supported by additional real estate, our assortment will expand to a complete lifestyle expression of undies and AE dorm wear. Based on successful test results, our bra collection will launch to over half of the chain this fall. Through research and focus groups with our customers, we know that the intimates category is a significant market opportunity. Right now, our AE girl has limited options in the marketplace. Aerie is a compelling and unique approach to intimates, staying true to our AE lifestyle. It will leverage our brand and expand the relationship we have with our existing customers. As we gear up for the launch this fall, we expect aerie to be a comp sales contributor with a complementary profit margin to the overall brand.

Regarding our new loyalty program, we are pleased with the AE all-access pass. Our strategy of replacing short-term coupons with long-term customer loyalty is truly proving successful. New enrolments are exceeding our expectations and the first two redemption periods were encouraging. Ae.com also performed well in Q1, with sales rising 45%, driven by increased, unique user sessions. In closing, I would like to comment briefly on our view of the fall season. We continue to evolve with changes in trends, body shapes and colors, providing freshness and energy to our assortments. This fall, we will build upon our leading market share position in jeans, which will reflect 90% newness while leveraging our brand strength in proven fits. We’ll offer updated styles, washes, treatments, fits and silhouettes as we prepare for our new assortment which arrives on July 11, we are running planned denim promotions to exit current styles.

While jeans are one of the key back to school categories, we are absolutely passionate about building success through a balanced assortment. We’ve built a meaningful non-denim bottom business and importantly, the right tees, tops and accessories for our AE customer. There will be plenty of freshness in trends and style this year and we are confident that we’ve put together a compelling assortment. Yet, as always, it’s our customers’ vote that truly counts, so stay tuned. I look forward to talking to you again soon and I’ll turn the call over to Joan.

Joan Hoxen, Executive Vice President, Chief Financial Officer

Thanks, Susan. Good morning everyone. We had a successful Q1, driven by stronger assortments, which delivered better than expected merchandise margins. Our margin performance was solid against remarkable results last year. We managed our inventory investments well, optimizing key categories through our (acceptable trigger?) strategy. Overall, our expenses were as expected, while investing in growth initiatives, including store remodels and upgrades, aerie and Martin & Osa. In time, we expect these investments to become meaningful contributors to the bottom line. Now let’s take a look at the details of Q1. Total sales increased 14% to $522 million. Comparable store sales increased 9% against a 27% increase last year. Q1 sales reflected positive store traffic trends, resulting in mid single digit increases in both units sold and transactions per store.

Our average until retail price and units per transaction increased in the low single digits, driving a mid single digit increase in our average transaction value. All geographic regions comp’d positively in Q1 as follows: low double digits in the southwest, northeast and southeast. High single digits in the mid-Atlantic region, mid single digits in the Midwest, low single digits in the west and high single digits in Canada. Turning now to our margin performance, our gross margin of 48.6% declined 10bps from a record 48.7% in Q1 of last year. Gross margin decline was the result of an increase in markdowns over last year, when our markdown rate was at a historical low. Looking at the components of growth margins, our merchandise margins declined by 60bps, partially offsetting higher markdowns, while giving(?) higher IMU. Buying, occupancy and warehousing costs leveraged by 50bps, primarily due to ramp. SG&A as a percent of sales was 26% compared to 25.5% last year, approximately $3.6 million of SG&A or 70bps was relating to stock option expense, which was not included last year. Within SG&A, we experienced leverage within store payroll costs, partially offset by increased supply expense. Additionally, we continued to absorb incremental expenses related to Martin & Osa.

We generated an operating margin of 18.9%, our second highest Q1 rate, while absorbing the stock option expense and costs associated with growth initiatives. Other income for this Q1 increased to $7.5 million, primarily reflecting a larger investment balance as well as a higher investment yield compared to last year. Our Q1 effective tax rate was approximately 40%. This compares to 39% last year. The higher rate was partially due to the tax repatriation plan to take place this quarter. For Q2, we expect our effective tax rate to approximate 39%. Income from continuing operations in Q1 increased to $64.2 million, compared to $55.2 million last year. Fully diluted EPS increased to $0.42 versus $0.35 last year, a 20% increase. Strong cash flow resulted in a $244 million increase in cash, short-term and long-term investments, to a total of $912 million(?).

Capital expenditures in the quarter were $36 million. For the year, we expect capital expenditures of approximately $215 million, which includes new and remodeled stores, our new Pittsburgh headquarters and new data center as well as our expected expanded Kansas distribution facility. The increase in capex guidance reflects additional store remodels and the accelerated construction schedule for our Kansas facility. At the end of Q1, total merchandise inventories increased $19.7 million to $195.3 million compared to last year. Our inventory per square footage cost increased 1.4% and our units per foot were down 2.1%, reflecting higher than expected sales in April. We continued to receive deliveries to support our summer business and we are comfortable with our overall inventory level and content.

Looking ahead to the end of Q2, we expect ending inventory to increase in the low to mid single digits at a cost per foot compared to last year. With respect to earnings guidance at this time, we expect our Q2 EPS to be in the range of $0.39-0.41. This compares to earnings of $0.37 per share last year. Our Q2 guidance includes stock option expense of approximately $0.01 per share net included last year. For the year, we expect stock option expense to total $0.04-0.05 per share. To sum it up, our Q1 performance demonstrates the strength of the American Eagle brand, our team’s commitment to delivering solid results and passion for our future opportunities. As we look toward the balance of this year, we are optimistic about our investments and growth and believe we are well positioned to deliver continued earnings growth. Thank you now, and I’ll open the call for questions.

Questions and Answers

Operator

Operator instructions. Your first question is from the line of Lauren Levitan with SG Cowan & Company.

Q - Lauren Levitan, SG Cowan & Company

Good morning. I wanted to have Jim give us a little bit more clarification on the remodels. Can you give us a sense of what percent of the chain will be meeting your standard by the end of this year, now that you’ve accelerated those plans and maybe a sense of what percent of them will be large enough to incorporate the broader aerie assortments? Then related to that, should we expect a higher capex to the level of this year to moderate next year? And how much cash are you targeting maintaining on the balance sheet to give you protection and room for investment going forward? Thanks very much.

A - Jim O’Donnell

OK, Lauren. The remodel program, as I said, is very successful and as we continue to be aggressive in remodeling, the majority of the stores, which really would amount to probably 95%, will be able to incorporate the expanded aerie collection. By year-end, I expect that we’ll have somewhere in the vicinity of 65-70 stores yet to be remodeled. That would take the portfolio, which in the next two years would be 100% branded with the minimal of our 2,000 designs. We feel that we’re in a very good place from a remodel point of view. We are looking at a new, updated remodel store plan that we haven’t made a decision on, that will take our new stores and our flagship stores to another whole level. But that’s more to come later.

A - Joan Hoxen

The capex, Lauren, in terms of normalizing, we expect 2007 to be lower than 2006 but higher than what we’ve seen in our history. In 2005 we reported a little over $80 million. We expect it to be somewhere in between. We have to complete the infrastructure initiatives that Jim mentioned. In terms of cash on the balance sheet, we continue to evaluate our opportunities for cash, Lauren, and we consider our investments in our growth initiatives as a very high priority. We are certainly doing that with the initiatives that Jim has spoken about. Further, we have a dividend program, as you’re aware of, and we continue to evaluate that as well as share repurchase.

A - Jim O’Donnell

As far as capex, we expect capex to level off next year, although we’ll still continue to be aggressive in our group initiatives.

Operator

Your next question comes from the line of Dana Cohen with Banc of America.

Q - Dana Cohen, Banc of America Securities

Good morning, guys, congrats. A couple of questions. You mentioned the margins of aerie being complementary, I think was the word you used. Can you maybe give us a better sense of where they are versus average corporate margins?

A - Joan Hoxen

OK, Dana. They are currently running at really right along and at the company trend. We see, longer term, the potential for them to be consistently slightly above company trends. Right now, we’re still investing and learning in that business. We’re seeing, again, very complementary, very consistent levels of margin with the main brand.

Q - Dana Cohen, Banc of America Securities

As you’re adding this product into the stores for the fall, is it a net increase in terms of product in the stores or is there something that is coming out to make way for it?

A - Joan Hoxen

That’s actually a really good question. We’re always, you know, one of the things in our business I think as a company we’re good at, we’re always evaluating profitable businesses, brands, market share building businesses and then ones that need to either be down-trended or maybe we need to step away from it. And there are some categories, as we look at maximizing aerie, in about 45 stores that we thought could be better used for an expanded aerie assortment. So we’ve made that switch and actually taken out some expanded assortments on the women’s side and I think from core, took some mixed standard assortments and moved them into an investment in aerie. But primarily, the expansion in aerie is by us taking advantage of square footage we currently have that we haven’t used to its full advantage. That’s what we’re going to start rolling out in the fall.

Q - Dana Cohen, Banc of America Securities

Last question, what would be the leverage point on comp as we move through the balance of the year?

A - Susan McGalla

I’ll take that, Dana. We see ourselves leveraging in terms of - I’m assuming you’re talking about SG&A?

Q - Dana Cohen, Banc of America Securities

Correct.

A - Susan McGalla

We see that at a high single digit comp in terms of leverage when we think about the things that we’re including this year, like stock option expense and the absorption of our growth initiative.

Q - Dana Cohen, Banc of America Securities

And that would be Q2 through Q4?

A - Susan McGalla

That’s correct.

Operator

Your next question comes from the line of Stacey Pack with Prudential Equity Group.

Q - Stacey Pack, Prudential Equity Group

Hi, thanks. On aerie, can you talk a little bit about how you’re going to market it differently, if you are? And I’m particularly interested in the kind of bra offering you intend to have. Is it sort of a cotton line or full support? And then for fall, as you anniversary the strong trends from last year, should we expect denim will be up as a percentage of the mix? How are you going to anniversary the AUR there and what can you say about the other bottom categories? Then just a follow-up on Dana’s question, on the leverage point. I believe that’s a higher leverage point than you have had, which I thought was mid single digits. So maybe you could tell us what the investment in the growth initiatives was in Q1 and how that changes for the rest of the year?

A - Susan McGalla

OK, Stacey, that’s a list but I think I’ve got it. I’m going to comment briefly on that leverage point, then Joan may want to follow up. The only difference in the leverage point of mid single digits to higher single digits is, I think, Joan is including for you the incremental businesses of aerie in that number. It’s really the core and the main brand is mid to maybe high singles, but really more in the mid range, and the high range includes the incremental aerie. Is there anything you want to add to that, Joan? I think that really clarifies the difference.

Q - Stacey Pack, Prudential Equity Group

Just to follow up there, you invested in aerie in Q1 as well, so are you saying it was high single digits really in Q1 also?

A - Susan McGalla

That’s really for the back half of the year. That was really the question, how are we guiding toward the balance of the year. We are certainly investing in the aerie business and there is an element of incrementality to that volume in the second half of the year.

A - Joan Hoxen

Stacey, to the question on the SG&A leverage, in Q1 we have incremental remodels and we do plan to have incremental remodels for the year. We’ve increased that number. That is a good portion of the investment that we’re talking about in terms of a higher leverage point. We are investing in Martin & Osa, we did say that as you recall, on the Q4 conference call that we have incremental investment in Martin & Osa in 2006, but less incremental than we were last year. That should address, I think, the SG&A question.

A - Susan McGalla

Then, Stacey, on your questions on aerie, a couple of things. How are we planning on marketing that? First of all, we are planning to truly, from a marketing perspective, have a launch for this aerie sub-brand right after Labor Day. That’s something that this company has never done before – launched a sub-brand. We’re very excited about it. We’re planning something very special that I won’t go into at this point, but one thing I will say, we have a constant eye on leveraging the American Eagle brand and our girls that we already have. That’s one of the beautiful things about this launch of aerie and aerie business in total. So we will be speaking to the girls that we already have coming into our store. The other thing, as it relates to the bra offering and the types of bras, we learned a lot. That’s why we run the business the way that we do. The customer’s smarter than we are. We put out there, in 100 stores, different types of bras and learned a lot about what they like, the number one bra that we thought was going to be number one wasn’t number one. We learned something else was. Those are the kind of adjustments on that, on sizing, that are worth taking when we’re moving bras in to an expanded number of stores on the fall side. Then, Jim also wanted me to mention that we had focus groups come in that we worked with on our bra offerings as we talked about launching them into the fall.

Q - Stacey Pack, Prudential Equity Group

So they’re not just cotton bras, then, Susan, they are, you know, different kinds of bras?

A - Susan McGalla

Have you seen, Stacey, our bra assortment that we tested, that we have out there currently testing? Have you seen it?

Q - Stacey Pack, Prudential Equity Group

No.

A - Susan McGalla

OK. There are several different types of bras. Again, we’re talking about launching the true lifestyle assortment and what our girl is interested in, cotton’s very important to her but it’s more than that and we’re going to be catering to her. The last question, to move onto the denim, you know you asked how are we planning that. We’re very, very serious about our market share position in denim. We are planning it up. As I said in my prepared comments, we’re very passionate though about delivering a balanced assortment. We will not live or die by denim in Q3 of this year, but it’s a major driver for our business.

Operator

Your next question comes from the line of Kimberly Greenberger with Citigroup.

Q - Kimberly Greenberger, Citigroup

Thank you. I was wondering, Joan, if you could talk about the changes that we saw, for example, in your sales and your gross margin line in the press release this morning versus the 10-K, what’s the adjustment for, to those lines? Also it looks like the prior year inventory numbers are also changing. If you could just comment on those adjustments that would be great.

A - Joan Hoxen

Thanks, Kimberley, for the question. In terms of sales, the difference in our 10-K reflects the change in the recording shipping revenue to the sales line. We do that not on a monthly basis, but we do that on a quarterly basis. With respect to inventory, this reflects, as you may recall at the end of the year last year, we changed our methodology in recording inventory in transit and we moved it from the point of deconsolidation to the point of shipping from the port that we’re sending our goods over to American Eagle. That would explain the changes to the inventory in transit on the balance sheet.

Q - Kimberly Greenberger, Citigroup

So you’re booking the inventory on the balance sheet at the point of departure at the foreign port and not when it arrives here?

A - Joan Hoxen

That is correct, yes.

Operator

Your next question comes from the line of Brian Tunick with JP Morgan.

Q - Brian Tunick, JP Morgan

Good morning, this is Anna for Brian. Just a quick question on how should we think about your merchandise margin for the remainder of the year. I think you mentioned that during the quarter, IMU was a little lower. If you could just give us some color on that? Thanks so much.

A - Susan McGalla

Sure. Let me clarify the IMU point. We actually experienced a higher IMU in Q1. Looking forward to margins in Q2, our guidance for Q2 reflects a realistic markdown rate, which is in fact above Q2 of last year. We believe that this allows is to present fresh assortments and seasonal updates to our customer on a normal cadence. But as in Q1, I believe that we have an opportunity to deliver again, a strong, high operating margin rate.

Operator

Your next question comes from the line of Jeff Black, with Lehman Brothers.

Q - Jeff Black, Lehman Brothers

Good afternoon. Congrats on a great quarter. I’m wondering, since we’re upping the remodels, I was wondering if you could give us a little more color on, I believe you mentioned a 70% increase number in the call, but what kind of benefit do you get from sales? What kind of benefit do you get on the operating margin line in year one? Based on what you know now, what’s the cadence of that improvement as you move into the year out period? Thanks.

A - Susan McGalla

Thanks for the question, Jeff. Our remodel and rebuild(?) strategy, what we found is that the economics that, you know, 70% profitability improvement is very strong. We were able to accelerate some of our deals to be able to do that earlier in the year. What we find is that as these stores mature over the course of their life, you know, through years three, four and five, we continue to see comp store increases which continue to drive higher operating margin rates for us. It’s something that we’re able to benefit financially over a several year period.

Q - Jeff Black, Lehman Brothers

Can you put a number on the comp benefit you see in the year out periods? I know that might be asking a lot.

A - Susan McGalla

I wouldn’t do that right now. You know, let us take a look at it and we can evaluate that information for you.

Operator

Your next question comes from the line of Richard Joffey, with Steeple Nicholas.

Q - Richard Joffey, Steeple Nicholas

Thanks very much. A question for Susan about what you’ve learned this Spring from seeing fashions you’re successful selling and how you see that kind sliding into your fall assortment. Then judging from some of your comments, it sounds like you’ll have more customer choices for back to school this year than in the past. Is that correct? How much broader will the assortment be, or is it just the dogs(?) we shifted around?

A - Susan McGalla

Couple of things. Do you really expect me to go into specifics about fashion?

Q - Richard Joffey, Steeple Nicholas

I have to ask.

A - Susan McGalla

I’ll answer it. I think that you’re referring to some of the changes in fashion that are occurring. I’m pretty proud of our team for approaching this the right way for the American Eagle customer. You know, with some of the changes occurring in fashion right now, for us it’s an evolution not a revolution. I think that’s quite important. We have some destination businesses, we make sure that our fashion basics are always modern, they’re always updated, and we certainly are very well aware of some of the changes occurring. I think you can see that in our existing assortments. We continue to learn, we continue to test, we continue to do focus groups and we’ll continue to evolve those assortments. I think you can see Q2 evolved over first. What we have prepared for back to school and fall is the next step in that. We feel we’re taking very appropriate steps in just about the right time that our customer is ready for those changes. We feel good about that. The other thing on the more customer choices, actually we’re very comfortable with the customer choice level in our main brand. Where we will be having some customer choice expansion in the business would be aerie.

Q - Richard Joffey, Steeple Nicholas

And that will simply be a plus? All those categories will simply be an additional set of choices?

A - Susan McGalla

Yes, those are additional choices where square footage and space allow. Before aerie.

Operator

Your next question comes from the line of Stephanie Wissink, with Piper Jaffray.

Q - Stephanie Wissink, Piper Jaffray

Good morning. I think we’re getting some feedback on the line.

A - Susan McGalla

We can hear it a little bit.

Q - Stephanie Wissink, Piper Jaffray

Two questions. First on your international expansion strategy, then second just coming back to Anna’s question earlier, speaking to your promotional activity, blocking(?) the stores recently (inaudible) very little promotion and is that in light of tighter inventory or have the promotions just not stepped up yet? Especially on the denim that you spoke to in your prepared remarks?

A - Susan McGalla

Stephanie, I’ll handle the promotional activity that you’re observing. I think a couple of things. First of all, you’re seeing us early in the cadence of our floor set. We’re about 2.5 weeks in to our summer floor set hitting and we’re very convicted and have been very successful. When our categories and our floor stats and our assortments are on the mark for our customer, we sell our merchandise at ticket for several weeks into the set. That’s all part of a planned strategy that’s been very successful. As always, though, and as Joan indicated, we don’t sit on merchandise and we know that we, 10 times a year, offer newness. That causes us to promote at the right times within a floor set cadence, to move merchandise, turn merchandise and make room for the new. So anyway, I think what you’re seeing on the floor right now is pretty typical of a successful floor set 2.5 weeks in. As I did state in my prepared remarks, we’re planning for a major update in denim for back to school and I wanted to clarify for all of you who know this, with jeans being such an important business for us, that the promotions that we have in jeans out there are planned.

A - Jim O’Donnell

Regarding international, I’ve made a decision to put the international initiative on hold temporarily. As you can see from our comments today, we have a number of major initiatives that we’re embarking on for 2006 that will go into 2007. At this particular time I don’t want to put any more strain on the company operationally than we have currently planned. International plan is finished, we’ve had some serious conversations with a number of people and we have some agreements in place that when the time is right I will activate those agreements and we will move forward into the international sector. Until I feel comfortable that we have our other initiatives up and running, it will remain on hold for a short period of time.

Q - Stephanie Wissink, Piper Jaffray

Just two more. Following up on an international comment, are you doing any marketing, currently, internationally? And maybe, what are some of the take-aways you’ve learned from the receipt of the brand in international markets, maybe speaking to direct international markets? Then secondly, based on the loyalty program, the all-access pass, any learnings from that, that you can give to us? Thanks.

A - Susan McGalla

A couple of points on the marketing internationally. The one thing we’re right now currently shipping to over 50 countries internationally. That’s been met with, as we said in past calls, it’s been quite successful for us. With us knowing we have our eye on international expansion, we’re going to be targeting through ae.com a successful marketing strategy to get our name out there and I think it will really help pave the way for us to move into successful international expansion when Jim pulls the trigger. We feel really good about those plans. The comment on AE all-access pass, our loyalty program, as I mentioned a little bit earlier, we’re very pleased. We continue to exceed our enrolment goals, which is very important. And I want to mention to you really that it’s not only just a loyalty program in the fact that we have redemptions coming back, this is about a relationship with our customer and we’re learning to, and putting together a very, very rich database about our customer. Don’t forget, in our demographic, our customer doesn’t always own the credit card. Now through this loyalty program, we’re learning a lot about them. There is the benefit of redemption periods, which early on, we’re quite pleased with. But there’s also the benefit of a very rich database that’s being put together to improve, as I mentioned earlier, that we are committed to having the absolute best customer relationship in our states. This loyalty program is really a 360 degree view of our relationship with our customer.

Operator

Your next question comes from the line of Jennifer Black of Jennifer Black & Associates.

Q – Jennifer Black, Jennifer Black & Associates

Good morning and let me add my congratulations. I was just curious, Susan, as to what items did you chase for the quarter and what did you wish you didn’t have? You mentioned men’s woven shirts you were phasing out. Is there anything else.

A - Susan McGalla

We’re kind of laughing, there’s always a couple, right? We’re in the fashion business. You know, I would tell you just overall, there were some businesses that we bet on that we did a pretty good job. I think right now we have one of the primary destinations for the short business in the mall for the girls and the guys, we bet on that early on but I will tell you it even exceeded our expectations. We mentioned the strength was broad-based across men’s and women’s in the short categories. There were some fashion trends changing like that. Some of the shapes in the tops, I will tell you, continue to show strength, and we moved after that. We’re really planning to operate that way and I think that’s the most important thing. As you know, early in February we get a very good read on our spring assortments, our early indications of what we bring in from summer to trigger in February and correct our summer assortments to see what you’re seeing today. It’s a part of the way that we work.

Q – Jennifer Black, Jennifer Black & Associates

OK. As far as the short lengths, can you speak to that?

A - Susan McGalla

The short lengths? I think if you come into our store today you’ll see all lengths. You’ll see short shorts, you’ll see the longer shorts. What our design team put together in that assortment is working quite well, really. I think that’s what’s happening. Shorts are a trend and the girls are wearing them every which way. I don’t want to leave the guys out, there are some changes in silhouettes that are reflected on our floors right now for the guys that also are working quite well.

Q – Jennifer Black, Jennifer Black & Associates

OK. Anything you wish you didn’t have?

A - Susan McGalla

There’s a few things. I won’t even go into details. There’s always a few items here and there. I will tell you our assortments right now, I think the important thing is they’re clean. Any of those hits we’ve taken and we’re moving on into Q2. I think that’s the important point.

Operator

Your next question comes from the line of Holly Guthrie, with Morgan Keegan.

Q - Holly Guthrie, Morgan Keegan

Thank you. Great job, everybody. A question on gross margin. Gross margin exceeded my estimate a little bit and I was wondering if you could talk about your initial assumptions for gross margins and how it played out in the quarter.

A - Joan Hoxen

Thanks, Holly. I’ll take that question. It’s Joan. The gross margin for the quarter, as you may recall we planned that at what we call a realistic markdown rate, compared to a very low markdown rate last year. It was our best ever. What we experienced is that we had very strong sales for the quarter and we our markdowns came in much better than expected and so we were able to also leverage our strong inventory disciplines in terms of our trigger strategy and our flow strategy. Susan and I really believe that that is what leads us to very profitable merchandise margin performances, up against some pretty tough results in history.

Q - Holly Guthrie, Morgan Keegan

Going back to the high single digit comps needed to leverage SG&A, I’m assuming that your confidence in your comps then has built, given what you believe is a strong good quarter of offerings as well as the incremental AE business. Is that correct, to support what looks like to be a forecast for a high single digit increase in comps going forward through the back half of the year?

A - Joan Hoxen

Let me address that specifically. In terms of the leverage question, as we looked at our leverage, we view it on a mid to high single-digit comp, depending on the quarter of the year that we’re in. As we looked at Q1, we had incremental expenses as we talked about. We had remodels and so forth. So as we move forward, our operating plans are in place to allow us to leverage in a range of the mid to high single comps on an annual basis.

Q - Holly Guthrie, Morgan Keegan

OK. Then just one question on the acceleration of investments. I’m assuming that everything that you’re planning for out years is congealing well and that’s why you’re accelerating the remodels and the DC construction and everything. Is that a correct assumption as far as the strategic overview?

A - Joan Hoxen

In terms of the remodels, the financial opportunity that it’s remodeled is really driving our decision to pull those forward. With respect to the infrastructure, I’m going to let Jim address that.

A - Jim O’Donnell

One of the things, and it sounds somewhat subjective, but you have insight into this especially apparel business within shopping malls. Location is extremely important and tends - almost in every remodel we have improved our positioning in the shopping center, both in physical position and in size. What has happened is it has generated more traffic and we have better presenting of our product. It updates our brand and the store ends up complementing the assortment and the assortment complements the brand. That’s why we’ve been seeing these productivity figures accelerated at an increased rate that we’re very pleased with and that’s what’s prompting us to accelerate the number of remodels that we originally planned, which were in the vicinity of around 50-55 up to 68. That’s actually the max for this year. All we can tell you is that this entire remodel program has proven over the years, it’s not just a one-trick pony. We’ve been doing this now for four years and we have enjoyed success every year, and the ones from four years ago continue to show increases in both top line and bottom line performance.

Operator

Your next question comes from the line of Christine Chen, with Pacific Growth.

Q - Christine Chen, Pacific Growth Equities

Congratulations on a fabulous quarter. Some housekeeping questions. Capex for the quarter? Maybe I missed it. After this year, how many stores will you have left for the remodel program?

A - Susan McGalla

The capex for the quarter was roughly $36 million. In terms of…

A - Jim O’Donnell

By year’s end, we’ll have less than 70 stores to be remodeled that would be in our old format from 1995. All stores within the next two years. In 2007 and 2008, all stores will have a minimum of the 2000 design, which is our white store, going forward.

Q - Christine Chen, Pacific Growth Equities

If you could just give us the floor set timing between now and back to school?

A - Susan McGalla

We have a minor floor set change that we’re always re-evaluating the best time for customers to put units out there. Last year, our summer two floor set, which has about 15% newness, it’s not a major update but there is about 15% newness and we do rework the way the floor’s laid out a little bit. That was set the week after Memorial Day. This year it will be set the Tuesday before Memorial Day to capitalize on Memorial Day traffic.

Q - Christine Chen, Pacific Growth Equities

OK. And the number of floor sets for the year is, I assume, the same from last year?

A - Susan McGalla

It’s still 10.

Operator

Your next question comes from the line of Dana Telsey with TAG, the Telsey Advisor Group.

Q – Dana Telsey, TAG

Good morning everyone, and congratulations. Susan, can you talk a little bit about the tiered pricing strategy? It’s been very successful for you. Are you going to extend that into other categories? And how you see AUR evolving through the balance of the year. Thank you.

A - Susan McGalla

Thanks, Dana. I want to quality the tiered pricing sort of buzzword that’s out there as it relates to American Eagle. We really don’t view it as tiered pricing. The reason I caution that is two-fold. We don’t tell our design team, you have to satisfy three price points in a particular category. We really go after it differently. We look at market share, if this is destination American Eagle, we go after market share opportunity, we look for expanded assortment opportunities within market share ideas. What we do is let our design team go crazy, come back, make sure they covered the fashion basics, but we let them really bring things that expand the assortment, make up the destination for a particular category and with tiered pricing if value permits, we let our prices evolve within specific categories. I think it certainly has proven to be a nice contributor to moderate AUR growth for us. I just have to say it’s price and value. That’s what quality and value really mean to the American Eagle brand. We’re very strategic about how we go after it, we’re very measured how we go after it, because we’re very passionate in our brand making sure that we are not over-assorted. We really pick our spots and go after these in a very targeted way.

Judy Mehan, Director of Investor Relations

We have time for one more question.

Operator

Your next question comes from the line of Todd Slater, with Lazard Capital Markets.

Q – Todd Slater, Lazard Capital Markets

Hi. All of our questions have been answered. Thank you.

Operator

Today’s final question will come from the line of Meredith Kent with UBS.

Q – Meredith Kent, UBS Warburg

Hi – I got in just under the wire. I just wanted to follow up on a couple more aerie questions. First of all, how big would you say the opportunity for this business is, in dollars? Also, could you talk a little more about the dorm wear part of the business? I’ve just been trying to get a sense of how that overlaps or could potentially cut into some of the tank or bottoms business that you already have.

A - Susan McGalla

That is a good question. A couple of things. The dollar opportunity in aerie, we’ve been out there with some numbers about some five year plus potential in the half a billion dollar range and up. We’ll see. Again, I think that we have a job to do. We’re going out there, we’re not talking about a small base of business that we’re starting with and we have six years of experience in building to where we are today. We’ll continue to keep you updated and on track to do that. We certainly feel that dollar opportunity is out there, plus some. The dorm wear piece, again we have experience in this. Dorm wear is actually how we started our intimates business at American Eagle. It really was about extending their lifestyle to what they can wear in their dorm room, hanging out, and they can wear out on the street to the coffee shop if they want. When we look at those assortments, we’re constantly putting those up against the main brand and the styles that we’re offering in the main brand, to make sure that there’s a lot of consideration to where there’s crossover, where it’s appropriate and where it’s not and we make those adjustments.

Q – Meredith Kent, UBS Warburg

Real quickly, are you going to have a separate website for aerie? Or is it going to be part of the American Eagle site?

A - Susan McGalla

That’s a great question too. They’ll be coming into ae.com, always. As I’ve said before, we are consistently going to be leveraging the American Eagle brand. They will be entering aerie.com through ae.com.

Judy Mehan, Director of Investor Relations

Denis, we’re going to take one more question, we’ve a little more time.

Operator

You next question is from the line of David Glick with Buckingham Research Group.

Q – David Glick, Buckingham Research Group

Good morning. Judy, thanks for that last question. Of course I’m going to talk about aerie. I was wondering if you can give us a sense for the results of your Q1 test now that you’ve had a full quarter of testing in the 30-40 stores that you’re testing in. Could you share with us what the overall comps were for those test stores, versus the chain average? What kind of penetration or percent of total you saw in the intimates business in those stores? What are you expecting for Q3 or Q4 in terms of the penetration of the business as you expanded out to over half your chain and what kind of incremental comp flagger(?) do you think it is? If you could attempt to quantify that.

A - Susan McGalla

A couple of things. First of all, I want to clarify, the only test we really had in place for spring was a bra test. I mentioned that we learned a lot, saw positive results in our expanding that into about half the chain. That’s just bras. For aerie, I want to clarify that aerie will be in 100% of the American Eagle stores and on ae.com in at least a small assortment, as myself, Jim, Joan, as we’ve all talked to you all about aerie we’ve mentioned that we have a very selectable real estate strategy that allows different levels of assortments to go into our stores. As that evolves over time, that will dictate how much of comp store growth our top line business will see. What we’ve proven, OK, and what has been successful as we continue to expand the intimates line you see out there in the store right now are two things. One is we’re getting better at the productivity of our expanded assortments. The side by side stores that we have, the large in-store square footage that we have, they’re becoming more productive to our business, so we’re learning about that. I mean, those were the things that we’ll need to keep you updated over time. We expect comp store growth from this business but we’re not going to put a number for you because the real estate strategy is going to be changing month to month, quarter to quarter.

Judy Mehan, Director of Investor Relations

Thanks, Denis, that’s it. Thank you for joining us today and we appreciate your time.

Operator

This concludes the American Eagle Outfitters Q1 2006 earnings call. You may now disconnect.

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Source: American Eagle Outfitters, Inc. Q1 2006 Earnings Conference Call Transcript (AEOS)
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