J. Crew Group, Inc. F3Q08 (Quarter End 11/1/08) Earnings Call Transcript

| About: J CREW (JCG)

J. Crew Group, Inc. (JCG) F3Q08 Earnings Call November 25, 2008 4:30 PM ET

Executives

Allison Malkin - Integrated Corporate Relations

Millard S. Drexler - Chairman of the Board, Chief Executive Officer

James S. Scully - Chief Financial Officer, Executive Vice President

Tracy Gardner - President - Retail and Direct

Analysts

Paul Lejuez - Credit Suisse

Kimberly Greenberger - Citigroup

Jeff Black - Barclays Capital

Brian Tunick - J.P. Morgan

Dana Cohen - Banc of America Securities

Michelle Tan - Goldman Sachs

Roxanne Meyer - UBS

Randal Konik - Jefferies & Co.

Christine Chen - Needham & Company

Richard Jaffe - Stifel Nicolaus & Company, Inc.

Barbara Wyckoff - Buckingham Research Associates

Operator

Welcome to the J. Crew Group, Inc. third quarter 2008 earnings conference call. At this time all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Allison Malkin of ICR.

Allison Malkin

Before we get started I would like to remind you of the company’s Safe Harbor language which I’m sure you’re all familiar with. The statements contained in this conference call which are not historical facts may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results might differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the company’s filings with the SEC.

Now I’d like to turn the call over to J. Crew’s Chairman and CEO, Millard Drexler.

Millard S. Drexler

Jim Scully, our CFO, is here along with Tracy Gardner, President of J. Crew, and other senior partners in the company. For today’s call I will begin with a brief overview and then Jim will cover our financials in more detail and update our outlook for the balance of the year as we want to keep this short so we can spend enough time answering your questions.

Needless to say we’re operating in an incredibly challenging macro environment. In the near term we’ve of course launched efforts to reduce costs in all areas of our business but we will not sacrifice the integrity of our strategy, our product or our customer service. We remain focused on building our business for the long term through our commitment to quality, style and design of our goods and prudent investments in inventory, real estate and our infrastructure. This commitment along with the strength of our balance sheet will position us well as the environment eventually improves.

We’ve had the benefit of being a private company within the last five years and are well versed in how to run a business for maximum returns and cash generation. It is what we do. When we got here it was our focus to surround ourselves with an experienced team who had been through the battles before and I feel confident we have the right team during this unprecedented time.

Turning to the third quarter highlights, total revenues increased 9% to $363 million with comp sales down 3% to last year and direct sales increasing 13%. While the quarter began as we anticipated for our store business and ahead of our expectations for direct, we experienced a pronounced sales decline in October in both our stores and direct channel with a notable decline in store traffic leading to increased markdowns during this time period. We reflected this lower trend in our revised full-year outlook which Jim will discuss in more detail later on the call.

Operating income totaled $33 million or 9% of revenues versus 14.3% last year. Our direct business which includes our catalog and online achieved a 13% sales increase in the third quarter on top of a 36% increase last year. We stabilized our direct systems infrastructure in the third quarter and aside from certain minor website glitches we have restored our ability to service our customers on our website, in the distribution centers and through our call center. As discussed on the second quarter call we experienced additional costs associated with the stabilization of our direct systems in the third quarter which Jim will discuss in further detail.

During the quarter we opened 15 new stores: 11 retail, two factory, one Madewell and one factory crewcuts store. We plan to open a total of 42 new stores this year 2008. Our third quarter retail openings included our Tribeca men’s store and our Collection store on Madison Avenue. We continue to expand our Madewell business opening our 10th location in Tysons Corner in the third quarter.

Our store productivity increased 1% to $568 a square foot from $561 last year while our square footage has increased 9% over the last 12 months.

Over the long term our priorities remain the same: To provide our customers with the best we can in quality, style and design across our retail, factory, direct, crewcuts and Madewell businesses.

In the near term our priorities have shifted to an increased focus on our inventory management. We will move through our current inventory as efficiently and as aggressively as needed to reach a level that is balanced with our sales trend. This is a time to micromanage every aspect of the business and watch every dollar we spend with more care and we are revisiting all new store openings effectively cutting square footage growth in half in 2009 excluding the planned openings for Madewell.

Our revised annual outlook which Jim will review in more detail contemplates the lower sales trend which we saw develop in October. We are taking a conservative approach to our business and continue to believe the macro environment will be a major challenge for the near term. As I said earlier these are unprecedented times. Given that, forecasting in this environment is difficult at best.

With that I’ll turn the call over to Jim to review third quarter results and outlook.

James S. Scully

Despite the macro environment we achieved the earnings range we provided on our second quarter call.

As mentioned we stabilized our direct system’s infrastructure during the third quarter. We are currently not experiencing constraints on our ability to capture, process and ship customer orders or to transfer product between channels. Our focus has now shifted from stabilization to preparation for peak. We have completed our testing and are working every day to ensure that we deliver a high quality experience to our customers during the all-important holiday season.

As we’ve all observed the current macro environment had a significant impact on consumer activity at the end of the third quarter. Our top line performance deteriorated in October versus our August and September trend. In order to highlight the extent of this decline we would like to provide our August and September combined sales trend compared to our October sales trend. Our August and September combined comparable store sales were down 1% and our direct sales were up 21%. However in October our comparable store sales declined 6% and our direct sales declined 2%.

We experienced a noticeable decline in store traffic in our stores and decreased conversion on our website. Both the store traffic and online conversion trends point to a more cautious consumer environment. The top line trend led to more aggressive markdown activity during the quarter.

Turning to the details. Total revenues increased 9% in the third quarter to $363 million. Our store sales which include our retail, factory, crewcuts and Madewell stores increased 7% to $251 million. This increase was driven by a 9% increase in net square footage with comp store sales down 3% for the quarter. Our direct business experienced a 13% increase to $102 million on top of a 36% increase last year.

Gross profit dollars for the third quarter were essentially flat to last year. Gross profit margin declined 400 basis points to 41.6% and was driven by a 310 basis point decline in our merchandise margin and a 90 basis point decline in buying and occupancy leverage.

The merchandise margin deterioration resulted from entering the third quarter with inventory per square foot 12% over last year which included approximately $15 million related to the direct system upgrade as well as the softened store trend. We also experienced markdown activity as a result of the pronounced decline of sales momentum in October and approximately $1 million in customer accommodations related to the direct system initiatives in the form of free and upgraded shipping and other customer appeasements.

SG&A expenses for the third quarter increased 14% to $118 million or 32.6% of revenues versus 31.3% of revenues last year. The deleverage in SG&A expenses was primarily the result of costs related to the direct system stabilization efforts in the third quarter. These costs totaled approximately $5 million and were responsible for 140 basis points in deterioration.

We also experienced a decrease of approximately $4 million related to share based and incentive compensation expense in the third quarter versus last year. Finally we continue to pursue expense efficiencies in all areas of the company and are continuing to take deliberate steps to align our cost structure with our top line trends.

Operating income totaled $32.5 million which compares to $47.7 million last year with the operating margin deteriorating 530 basis points to 9%. As I mentioned operating income was negatively impacted by approximately $6 million in costs related to the direct system stabilization efforts which was $2 million more than originally anticipated.

Net interest expense for the third quarter totaled $600,000 compared to net interest expense of $3.1 million in the third quarter last year. The decline in interest expense primarily reflects our lower outstanding debt and interest rates related to the term loan. Additionally the third quarter included the recognition of interest income associated with the collection of a tax refund.

Income before income taxes decreased 28% to $32 million as compared to $45 million last year. Our effective income tax rate was 40.5% for the quarter as compared to the prior year effective tax rate of 39.8%.

Net income was $19 million or $0.30 per diluted share compared to net income of $27 million or $0.42 per diluted share in the third quarter of last year.

Turning to the key balance sheet highlights, cash and cash equivalents were $114 million at the end of the third quarter and include the impact of income taxes paid of $53 million and voluntary principal payments of debt of $25 million during the last 12 months. In addition to our growing cash position we have a $200 million working capital facility inaudible]

inventory related to the disruption during our direct systems upgrade. Our ending quarter balance reflects the unanticipated deterioration of our sales trends during the third quarter. Our inventory balance also reflects the impact of 35 net stores opened since the third quarter of fiscal 2007 and 30 stores opened since the end of fiscal 2007.

Capital expenditures for the third quarter were $25 million. Our full year forecast for capital expenditures remains at approximately $80 million. We are currently working on reducing capital expenditures for the remainder of the year. We have targeted cuts to reduce 2009 capital expenditures by approximately 25% versus 2008.

Turning to the outlook. Given the macro economic backdrop and declines in store traffic and the resulting impact on our sales trend, we are revising our outlook for the balance of the year. We have based our guidance on the trend we saw develop in October and our assumption is for this to continue.

For the fourth quarter we now expect diluted earnings per share in the range of $0.05 to $0.10 which compares to $0.39 in the fourth quarter of fiscal 2007 which included the impact of a severance charge of $0.02. Our fourth quarter outlook reflects comp store sales in negative high single digits, direct sales growth in the flat to mid-single digits, operating margin deterioration of 800 to 900 basis points with gross margin deterioration of 700 to 800 basis points and SG&A deterioration of approximately 100 basis points.

SG&A includes approximately $3 million in costs associated with the direct system enhancements in the fourth quarter. We expect to end the fourth quarter having cleared the majority of the residual inventory that resulted from the second quarter systems disruption as well as the appropriate amount of fall and holiday goods.

For the full year we now expect diluted earnings per share in the range of $1.11 to $1.16 as compared to our previous guidance range of $1.44 to $1.54 and compared to fiscal 2007 diluted earnings per share of $1.52 which again included the impact of a severance charge of $0.02. Our full year outlook includes annual net square footage expansion of approximately 10%, an effective tax rate of approximately 40%, approximately 40 million diluted shares outstanding, capital expenditures of approximately $80 million, and approximately $11 million in losses associated with Madewell.

Before I turn the call back to Mickey, I would like to take a moment to give some additional color on our inventory position. On a year-to-date basis through the end of third quarter total revenues increased 11% to last year with comparable store sales essentially flat and direct sales up 14%. Operating income was down 9% and EPS was down 6%. While this is clearly not the height of our aspirations, we do view it as strong relative performance given the environment we have been operating in.

Having said this, the drop-off in October was rather significant. As I’ve mentioned, comparable store sales declined 6% and our direct business declined 2%. This sudden and rather significant shift this late in the year has obviously put pressure on inventories. We are taking aggressive actions to move through the inventory during the holiday season and our guidance contemplates us clearing through our fall and holiday merchandise leaving little carry-over inventory.

However, the trend we are now projecting is lower than we had previously contemplated when we purchased spring and summer inventory. As we’ve discussed in the past we buy inventory on the halves, and while we feel comfortable with our aggregate purchases for the first half of next year assuming the sales trend does not worsen, there will be more pressure on the first quarter than the second quarter and point in time inventory calculations will continue not to be the best gauge of our inventory position for the first half of next year.

We will obviously provide more detail on our year-end call. Now I’ll turn the call back to Mickey.

Millard S. Drexler

As we move into the holiday selling season we’re focused as always on satisfying our customers’ apparel and accessory needs and providing them with the best service we can. We continue to maintain and will always maintain our long-term focus while doing everything we can do to mitigate any near-term risk while maintaining the integrity of our business. I believe that’s an extremely important mission that we have in times like this, and that integrity will in fact be the critical issue for us long term. We are very much committed to that. It’s our mission.

I believe that if we remain disciplined in our investments and focused on innovation in our products, again part of our mission, and servicing our customers, again part of our mission, with high quality merchandise, part of the mission, we will emerge from this economic crisis an even stronger company.

Now we’re ready for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Paul Lejuez - Credit Suisse.

Paul Lejuez - Credit Suisse

Mickey, does this environment change the way you view the long-term store potential of the J. Crew brand? You mentioned pulling back on growth for next year. Maybe you can give us some quantification of how many stores you plan to open there?

James S. Scully

Just in terms of quantifying it, excluding Madewell which we said was going to be 15 units and now we’re saying 10 to 15 units as we evaluate some unsigned leases, if you look at the core of the business, what we’re saying is approximately 4% to 5% square footage growth versus the traditional 7% to 8% square footage growth.

Paul Lejuez - Credit Suisse

In terms of pulling back versus long-term pull? That’s what I’m hearing?

Millard S. Drexler

Long term, again there’s kind of a short-term war going on here and long-term frankly if I had to pick a position to be in in our industry today, it would be at J. Crew and Madewell and our factory business. I say that because if you look at the world, there’s an enormous seed change happening at this point and I like the position we’re in. It’s clear that the Golden Age is over on the high priced goods that frankly don’t provide great value.

But in the short term it’s prudent and wise for us just to not rush. We think, we don’t know, if everything else is falling in value, why not real estate. We’re seeing much more flexibility in that market place and frankly we want to sleep at night.

It’s just our opinion at J. Crew, but we have a design team, we have our own products, we deal with the best factories in the world, we’re getting incredible recognition on that as is exhibited by our Collection business, our high end business, and we have very friendly opening price points, and our goods are not available in every discount outlet in America. They are only available in J. Crew.

If you look at the high priced business today, you can see clearly that any customer in the world with online ability can find a better deal on most things. I look at those stores as developers with real estate as much as anything else and the fact is if you want J. Crew, you buy it with integrity in our stores and there’s a value proposition which has never been more important in so long it’s incredible.

So the reason we’re cutting back on stores is it’s prudent, it’s conservative, we’re cutting back less on Madewell, and you don’t know but we’re willing to take the chance that the rents will be lower. I don’t think they’re going to be much higher. Penciling out deals these days has to be done with a very, very conservative mindset. If it doesn’t pencil out and it’s not signed, it’s being revisited as we speak.

Paul Lejuez - Credit Suisse

Can you give any color on factory price during the quarter?

Millard S. Drexler

Do you mean results?

Paul Lejuez - Credit Suisse

Yes.

Millard S. Drexler

We never do that. I hate to answer like that.

Paul Lejuez - Credit Suisse

Jim, any low-hanging fruit that you would call out on the SG&A side as we look out to ’09?

James S. Scully

Needless to say we’re turning over every rock but I think the primary areas of focus right now obviously are getting store payroll in line with the current sales trend. Obviously that’s a huge bucket of expense for us. The second is really the supply chain from end to end as we look through freight and every other aspect in our DCs and how we ship to the stores. Then if you look at overhead costs, that has a compensation factor and obviously I think we’re like every other company in America with a hiring freeze on. And then there’s the non-comp expense which is small areas like supplies, travel and every other area you can think of.

Operator

Our next question comes from Kimberly Greenberger - Citigroup.

Kimberly Greenberger - Citigroup

Mickey without getting as specific as providing spring inventory guidance, maybe you could just from a very high level talk to us about how you are thinking about the inventory buy going into 2009. At what sort of level of conservative would you like to see it? And when did you in fact start buying spring and has your thinking changed since you started buying spring until today?

Millard S. Drexler

We started buying spring about nine months ago so our thinking has very much changed because I think none of us expected what’s happened in October and November to happen. The thinking has definitely changed but the inventory for first quarter is what it is and with whatever the misses on plan are we’re dealing with right now. I think the important thing now is the first markdown is usually the most profitable. The longer we wait, the more it costs to move. So our attitude is on a long-term point of view is get through the short term incredible bumps that are out there.

But we’ve been more conservative for spring than we have been because in the last few months this thing has kind of started to creep up on us. So we’ve tried to downsize inventory in relation to our sale assumptions. We weren’t aggressive even before this happened because we kind of have low comp rules here. But the fact of the matter is we buy inventory as carefully as we’ve ever bought it right now, review every buy, and I feel very comfortable. At the end of the day I like the way our stores look. I mean, our customers like it. It doesn’t matter what I think.

But the October trend extraordinarily changed our thinking in an extraordinarily, not just an ordinary instead of a plus comp there’s a minus comp; October was in fact something unprecedented because the consumer dropped out. Not only did she drop out and he dropped out, the competition started marking the goods down because whatever our inventory position was, it was devalued by everyone else’s inventory position.

You can go out there today and designer goods, other goods, branded goods in some of our most famous department stores are 50% to 75% and more off. So that devalues the value of everything we’re dealing with. I don’t want to say I feel comfortable about it, but I think from an inventory content style point of view in all of our divisions I’m actually pleased with what it looks like. The only thing we can do is do the best we can and I think it’s very manageable.

We declared a recession, if only we knew last January how difficult it would be we might have been a bit smarter today. But I think it’s manageable and I think we’re playing a very competitive game. I don’t want to repeat this but I really like our positioning.

There’s a huge migration going on in America now from high priced I-need-to-have-it might-not-be-able-to-afford-it goods to in fact high quality more value intense goods. Because shoes at the prices they sell for, handbags and apparel at the prices they’ve sold for over the last number of years is not happening any more. That’s our viewpoint. That’s our opinion and I think we stand to benefit.

Our style and quality, which you know we’re on a mission to continue to communicate out there, and our design team, we’re in the designer business but we’re in it at prices that are not at the levels that everyone else is in it at. There’s no reason. Remember we’re also a direct-to-consumer maker of goods, we’re a direct-to-consumer buyer of piece goods, and the rest of them have a lot more markups and profits involved. And we control our environments. Wherever we sell we control.

And lastly, our goods are not roaming around America in every discount outlet, online or in so-called remote stores which are not that remote anymore.

Operator

Our next question comes from Jeff Black - Barclays Capital.

Jeff Black - Barclays Capital

We’re supposed to sit here and believe that you just got the memo in October about inventory? Correct me if I’m wrong, I thought we were down comp in 2Q. So when do we finally get some kind of confidence that you guys are ahead of the game and that we don’t have a 1Q that looks like this? What is one thing we can hang our hats on to let us know?

Millard S. Drexler

I think there’s more than one by the way, but Jim will explain the answer to that because unless you’re in our business I’m not sure you understand how it works.

Jeff Black - Barclays Capital

Weren’t you the guy that told us that there was a recession back in January?

Millard S. Drexler

Let’s play polite here okay? There’s no reason for that. We’re trying to do the best we can do. I don’t ask you to buy our stock and you don’t have to. But let’s play this game professionally and politely, okay? That’s all I’m asking for.

Jeff Black - Barclays Capital

Fair enough. So give us something to hang our hats on that shows us that you’ve got inventories down for spring.

Millard S. Drexler

Do you want to listen to the answer now?

James S. Scully

We go through the first nine months of the year. Revenue is up 11% and comp is flat. So I’m just going to throw the numbers out. Direct is up 14%. First, I don’t think we are in the death spiral that some of the competitors are that you’re looking at that are closing stores, cutting inventory by 25% because they’re shrinking their business for a whole host of reasons. If you look at the trend and it dropped off in October for the third quarter, the first two months, it fell off rather significantly.

I guess if anybody knew the extent of what was happening in October with the consumer, we’d probably have a lot more independent banks around and we’d have a lot less pain going on and a lot less people accepting public financing. I think things are different today unless I’m reading something differently and that did catch us by surprise and I don’t think we’re alone.

When do we get spring down? When do we get in front of this trend? I think when the trend stabilizes. Have we been chasing the trend downward? Yes. Do we wish we were in front of it? Yes. If the trend stays the same where it is, we’ll be in front of it by the time we get out of Q2.

Jeff Black - Barclays Capital

Fair enough. And just for the record, I wish you the best guys. I really do.

Operator

Our next question comes from Brian Tunick - J.P. Morgan.

Brian Tunick - J.P. Morgan

Mickey maybe just talk about how you think the brand gets back to a full price business next year after we’ve seen a lot of customers obviously coming in and seeing additional 50% off clearance and things like that. And maybe Jim just as far as the fourth quarter revision to guidance between stores, outlets and maybe direct, where is the biggest hit to your profit plans? If you could just talk about that; I know you don’t give it specifically.

James S. Scully

I guess the second piece is I think the biggest shock is we’re anticipating a flat to slightly negative comp trend and we came out with the high single digits. That’s one piece. The second piece is the direct piece. We saw a significant shift in the direct business which we highlighted with our October trend going from a +21% to a -2%, and I think everybody knows the operating model there in terms of the leverage we get that hurts going down as much as it benefits going up.

So I’d say given the order of magnitude when we went from high single digits to a flat to mid in direct and then if you look at the flat to slightly negative, I think they’re pretty much equal. Although the sales itself for direct are slightly less in terms of magnitude, the profitability impact is probably comparable between the channels.

Millard S. Drexler

Tell me what you wanted me to respond to again?

Brian Tunick - J.P. Morgan

We watched you the last couple of years. Your gross margins have been up I think 700 basis points. You’ve run a very full priced business. Now what happens going into 2009 is a lot of your customers are probably looking for the additional 50% off clearance you’ve been offering them. How do you reposition J. Crew to get back to a full priced business going forward?

Millard S. Drexler

I think that’s a really good question. I think the entire industry and the world is in the same position. Frankly it’s a couple of things here and I wish I had a crystal ball on that. I think the reset button has been pushed on value in America; homes, cars, gasoline, clothing, apparel, stocks, and everything else. So I think it’s hard to figure out when we come out of this. It is all about inventory management. In spite of my last discussion I totally agree with what was said. It’s all about inventory management and the quality of the goods.

I will tell you what we’re doing without talking too much to our competitors. There’s clearly an opportunity. It’s interesting. Believe me, none of us is having fun running businesses today I don’t care what the business is. But I think what’s going on is a lot of this is playing into our hand in terms of our opening price points where in fact they were at some times higher than we’d like.

We’re going out with categories this spring; it’s too late now because it is what it is; and I think consumers are driving it and determining retail. But our ballet flat category will start at under $100 for the first time ever. We’re doing T shirt businesses at prices with good margin by the way and margin’s a function of sell-through along with high initial margin. So in some cases, this is all merchandising, you might take a point or two off initial if you can get better sell-throughs.

We’re looking at the competition now in that regard too. It’s not a hope because hope is not a business strategy but it’s a fact that when you have better goods at value, customers always recognize that. Having been through this a couple of times before in my career, the right goods win out if you’re managing the inventories correctly. So I don’t want anyone to think that’s not a critical issue here. We’ve all been caught by this tailspin of consumers not shopping other than for sales but we have key categories like ballet flats.

We’re weighting our inventory differently than we have this past fall. You’ll see inventory weighted towards more friendly price points so that it kind of averages out. And it’s all again dependent upon the inventory and the sell-through. But I think the reset button’s been pushed on price and I think we’re all dealing with where that will end up.

However as I look at the landscape out there I really like where we are and I’m not making any false promises because who knows, but I just like the fact that we have great integrity and we maintain great integrity in our product mix and assortment, in our service, in our catalogs and online. And I think the customers will have less choice. If they are price customers in fact in any business, there’s always going to be a lower price.

But I think that’s going to be really the billion dollar question for the retailers: When will they trust your prices again?

Operator

Our next question comes from Dana Cohen - Banc of America Securities.

Dana Cohen - Banc of America Securities

On the guidance for Q4, in stores it’s slightly worse than October and in direct it’s slightly better. I’m just curious as to the whys of that.

James S. Scully

Obviously I don’t want to comment on current business but I think as we sit here today in week four we feel comfortable with the guidance that we’ve given. I think we view that October in direct is slightly in terms of a trend. It was sudden and we’ve seen it recover. So I think we feel comfortable at this point.

Dana Cohen - Banc of America Securities

Mickey going back to the inventory question, I think it is fair to say that the world has been slowing now for many months. Does this raise the question of perhaps looking at your sourcing differently today, that the old traditional nine month lead times may need to be retooled and perhaps you need to sort of inject more flexibility into your sourcing organization so that you would be able to react more quickly one way or another?

Millard S. Drexler

I think one is always looking at that. I’ve been hearing about quick sourcing now for about 15 years and some very famous retailers talk about it all the time and not so famous. We are not in the fast fashion business. To source at the level of quality that we are in is not fast.

Now when you say nine months; we do buy piece goods at times where we might stock piece goods but even then the dynamic changes in our industry is so rapid that we don’t even want to own a lot of piece goods at any particular time because of the fashion changes other than in some classic fabrics. Knits are easy; wovens are very difficult. But in the quality business with our assortments it’s actually more difficult in J. Crew than say it might be in Madewell or say in some of the factory businesses. Woven materials require fabric piece good buying and quite long lead times unfortunately for us.

Dana Cohen - Banc of America Securities

Is it fair to think that comp inventories will be in line with current trends by the end of Q2?

Millard S. Drexler

I’ll give you a qualified yes but my partners here, Tracy and Jim, say absolutely. But then again the only thing I will say is no one I’ve heard in America or in the world has figured out what is going on now with an intelligent simple understandable answer. So if I were to say yes, I say yes -

Dana Cohen - Banc of America Securities

Yes, barring the world continuing to get worse?

Millard S. Drexler

Exactly. Don’t holler at me in three months if in fact the world’s much worse and it’s not. We buy inventory based on plan and I think we’ve said before we never plan more than a five comp. That rule has changed. That rule changed probably in August or September. We bought spring nine months ago so yes, we did declare it was tough out there but for us tough was a relative figure. By the way, tough is relative for everyone. I was in one of the stores yesterday with 75% off the entire store. So that affects us all. I’m just telling you the truth in what we see and what we don’t know. It’s really hard to forecast it.

Dana Cohen - Banc of America Securities

How much of the delta in the gross margin between Q3 and Q4 is the between comp and inventory and how much of it is the markdowns you’re seeing out there competitively?

James S. Scully

It’s hard to quantify. I know what you’re asking. I would say 60% to 70% is the spread and I’d say the rest is competitive.

Operator

Our next question comes from Michelle Tan - Goldman Sachs.

Michelle Tan - Goldman Sachs

I was wondering if you could give us any more color on the deceleration that you saw in sales? Anything regional that’s notable? Anything in terms of different price points performing differently?

James S. Scully

We’ve looked at it every which way. We’ve looked at it regionally; we’ve looked at it by pricing; and what we saw was a shift. It was a reset. It was kind of the old economic shift where it wasn’t one pocket; it wasn’t pricing; it wasn’t regional.

Tracy Gardner

Every category across the board.

James S. Scully

Yes. It was a shift and we saw it consistently. We have not seen some of the deterioration some people have seen in some regional pockets. It’s been very consistent with the overall trend, although in September I think the West was marginally bad.

James S. Scully

Then it got better. It’s really hard but I think it’s kind of a general broad slowdown. There are stores we have that are doing well but generally speaking it’s not terribly specific. I know there’s been a lot written about exposure to the Northeast and Manhattan. We have not seen that market specifically perform worse than the overall business.

Michelle Tan - Goldman Sachs

Nothing on the price point side? You said all categories at all kinds of levels of price point?

James S. Scully

Yes. It wasn’t like an alarm went off based on -

Tracy Gardner

It wasn’t like an enormous over-purchase or a big bet made wrong. It was definitely the feeling of a reset.

Michelle Tan - Goldman Sachs

Have you stopped constraining traffic to the web and are you now able to redirect some of the store clearance back to the web the way you have in the past?

James S. Scully

Yes. We are driving traffic to the web and I would say that we have the operational capability to transfer goods between direct and retail. Now it’s a matter of just in terms of where the inventory is and where we see the best sell-through in terms of how we’ll capitalize on that.

Tracy Gardner

But we have not been constraining traffic. We’ve been driving it in fact.

Michelle Tan - Goldman Sachs

Throughout the whole quarter?

Tracy Gardner

Absolutely.

Operator

Our next question comes from Roxanne Meyer - UBS.

Roxanne Meyer - UBS

I’m just wondering on a positive note what customers are willing to buy at full price or if there’s not that much to mention there, what items are they gravitating to and what items are they saying no to the most?

Tracy Gardner

What we’re seeing is, perhaps some of you have it on, there’s a beautiful ruffly blouse. There are a lot of good indicators that are great. We hate to call them graphic T’s but the T shirts that have all the fabulous embellishment, embroidery are blowing out. Our match stick cords continue to be phenomenal; our match stick denims. We see a lot of lights.

There’s good response inside of our product for sure. It really feels like a reset. There are some really fantastic things; color, the customer is still responding to our color. I guess they’re still responding, the ones who love us, to what we strategically positioned ourselves to be. They still love our cashmere cardigans.

Millard S. Drexler

It’s still a shorter answer than it’s ever been. Other than on 79th and Madison, everyone thinks we are the free store in the neighborhood. That’s been quite extraordinary. The mindset is, and I think we all feel it, is why trust that it won’t be on sale next week. That’s why it’s a pretty short answer now. The ruffled blouses are wildly successful and our embellished T’s. We can talk about little tiny businesses but it doesn’t mean that much to the total. Jewelry. But by and large the world is not buying at regular price. We’re doing our best.

Roxanne Meyer - UBS

On SG&A in terms of your guidance for fourth quarter, I guess I’m pleasantly surprised that it’s only being managed up 100 basis points. Can you provide more color?

James S. Scully

We’ve been at this really since the end of Q2 when we did see the trend change. We’ve been as I mentioned pretty aggressive in terms of freezing open heads in the corporate office and attacking all aspects of it in addition to the store payrolls. We’ve made progress. I think we’re trying to make even more progress as we align the cost structure to the sales trend as we enter into 2009.

Roxanne Meyer - UBS

Even though you haven’t provided ’09 guidance, at this point is there anything you can say about dollar growth in SG&A?

James S. Scully

Not at this point. It’s too early.

Operator

Our next question comes from Randal Konik - Jefferies & Co.

Randal Konik - Jefferies & Co.

Mickey, quick question. You’ve talked about it in the past about the J. Crew positioning from an accessible or aspirational kind of luxury perspective and you kind of gave us some color here that the game has changed. We’re moving more to a value environment. Can you kind of give us a sense as to how you think the pricing paradigm of your business heading into this type of environment?

Then a related question for Jim, how should we be thinking about the margin opportunities for the business from an operating margin standpoint long term since we’re entering this new challenging environment here?

Millard S. Drexler

I think that’s a good question and not so easy to answer because there’s a lot of unseen things going on in the world or things that aren’t easy to predict.

As I said before we’re categorizing, we’re identifying certain opening price points. If you look at our January catalog, you’ll see a ballet flat assortment at $98. This year I think they started at $128. You’ll see T shirts. And by the way, it’s also positioning. Merchandising and communicating positioning, you’ll see a T shirt assortment $18 and up aside from our famous favorite T. Spring and summer by the way does make it easier for us because we don’t have the outerwear categories and the more expensive categories.

I think that for us there’s good news/bad news. The business is value but I think a quality consumer we see dramatic change going on with as I said people I don’t’ want to call them trading down but we see a really nice movement from designer competition at higher levels in all the shopping centers around America.

We’re out in the cities regularly and we’re getting a lot of the so-called better stores’ customers in who are now frankly buying our cashmeres, buying our jackets, are confident enough and it’s been validated by all their friends and it gets further validated by, I mean it sounds silly, but even by Michelle Obama, which had a huge impact on publicity. I can’t say she drove plus comps but I think we’re in a nice position in that regard.

And frankly at the end of that day our pricing compared to, and I won’t name the vendors, designers, other vendors are I would say much more value. I don’t want to say this; I’ll sound partial; but better looking style-wise. I think the one thing we get from our consumers worldwide or US wide is how they like our goods in women’s and I might say our men’s business is actually showing a lot of improvement in that area too. It’s a hard thing because we’re in this lower tide situation but I think the goods themselves are really getting a lot of recognition.

But I think there’s a big migration going on and we’ll continue to better value, not over priced goods. I think when you look at our cashmere for $148 or $168, if you look at some of our jackets from $295 to $500, try buying a better jacket in America; a well-made jacket in men’s or women’s either in cashmere or in fine quality wool for less than $1,000. That’s a game we’re playing very aggressively but kind of being subtle at the same time. It is a mission.

When you look at our catalogs going forward and our online, we’ll have more of a vocabulary of terms teaching people what our leathers are and so on and so forth. But I think that’s a long-term thing. I think on a positioning, the world has never been in our opinion, plus remember we don’t’ want to be the biggest. It’s not like we’re trying to go from $10 billion to $15 billion. We’d like to go from $1.3 billion or $1.4 billion to the next level whatever that is. We don’t want to own the whole market. We don’t’ want to be the cheapest player. We want to be the longest-lasting high integrity quality player and I think it’s working in terms of ubiquity of high priced goods.

You cannot discount, no pun intended, the fact that the fancy goods around the world are available in more places than anyone would ever have imagined five or 10 years ago. All these better stores have built their business with vendors, not with creative innovating taking on of new product or new resources. And look at the wholesale markets today. They’re a mess. How can you supply new goods in all these stores out there who don’t in fact have t heir own design teams when some of our biggest resources of the past in the apparel world are actually either gone or changed dramatically or in the condition they’re in right now?

I don’t want to say it’s like the American automobile industry that we’ve been listening to, but you know something? It’s not that different. Innovation wins whether it’s Apple or whether it’s Toyota or the Japanese makers or some of the German makers. We’re in the innovation business and that’s what we love doing and that’s what we think will continue to drive our customers to shop with us.

Randal Konik - Jefferies & Co.

Agreed. But I guess the question I come to is you kind of have two customers. You have that trade-down customer that had those better goods but I’m thinking more of the suburban mom out on where I live in Long Island and so forth and your stores are located in the malls. How do you think about that shopper where your price points have moved up in the last couple of years? How do you think of the pricing paradigm addressing that less fortunate kind of customer?

Millard S. Drexler

If they’re less fortunate, they’re probably not coming to J. Crew in the first place. I think what you’re seeing is interesting. Friends of mine and people I know work at Saks in [Burgdorf]. The customer shopping those stores today, and I wasn’t there so I don’t know, it’s not the normal customers. There are a lot of bargain hunters out there who are, I don’t want to say they’re grave dancers but why not take advantage of 50% to 75% off of goods.

Our core prices are not very high. They’re lower than most department store brands. You’ve got a large competitor that does about $5 billion at retail whose prices are actually considerably higher than ours. 85% of our goods are under $100. I just don’t want the tail wagging the dog on that. Our strategy initially was to go out there, be the best we could be, but we know most of our money is made under $100 through good times and not good times. The largest share of our top business is $18 to $78.

I hear what you’re saying and we’re sensitive to it because we’d be crazy not to. Right now what you’re seeing is a different behavior. It’s what’s on sale through our loyal and non-loyal customers. It’s what’s on sale and they’re buying it. We’ve all got to kind of beat the others out because at the end of the day if you’re waiting till January, your prices will be much less and people are not spending money now. They’re spending much less and they’re not shopping.

I don’t want to paint a dreary picture; it’s pretty dreary anyway; but they’re not spending. I’m not too worried about that because if all that disappears, then the whole world is so different anyway. I always have to count on for our business and our shareholders that there will be in fact people who have quality taste.

I remember when I first started shopping in Europe from Bloomingdales. Europe then was always in the 70s. Lesser units, higher quality and the best won. I think what’s happening is in America the mediocrity has risen along with the best over the last five or 10 years. I think those days are over. You can’t compare a GM car or price it to Toyota in quality. I think maybe that will now happen. It’s been happening in cars. I think it’s going to happen in American fashion or apparel if in fact the prices are too high. People want the quality for the value.

Randal Konik - Jefferies & Co.

Do you think the long-term margin structure changes in the business now?

James S. Scully

Obviously given the current environment we’ve come off our track this year in terms of the past when we had to get to the mid-teens in terms of the operating margin. Right now we’re extremely focused on the present in terms of Q4 and how we get positioned for next year. If you take a step back and look at the actions we’re taking on expenses and capital and all those things, I think it actually sets us up pretty nicely. We don’t see anything structurally that when the macro environment eventually comes back that we won’t be back on the same path.

Operator

Our next question comes from Christine Chen - Needham & Company.

Christine Chen - Needham & Company

Mickey from your comments earlier, it sounds like the more trendy or fashion items are selling a little better than the fashion basics which was something you’d seen at the beginning of the year. I’m wondering how the mix will be skewed in spring and summer?

Millard S. Drexler

Trendy is probably not a J. Crew term as much. Our biggest business is still corduroy jeans right now; of course on value like everything else is. I would say it this way. It’s newness, flow; when there’s an emotional item in the store like the ruffled blouses and I wish I had more on the list, cashmere colors are incredible; embellished T’s. So it’s emotional.

One of the things we’re doing is please don’t buy the classics in too many colors and in too many versions thereof, whether it’s a men’s chino pant; they don’t need four versions of it. They need two this year. Whether it’s T shirts that are your classic basics. So we’re trying to identify niches where we have add-on value. But I think the days of putting goods in, and maybe because I’m sensitive to this I never call anything basic or classic in our company, I always call it a wardrobe piece to get started along with everything else, but I think as we go forward the clothes -

We got new delivery in this week. I think if you go into the stores, wade through some of the promotional prices, you’ll see that our clothes need to look good-looking, pretty; the men’s clothes have to have integrity. But I would say yes, newness is more important than ever. Differentiation of your product is more important than ever. The one beautiful thing about customers is they notice those differences and those details. No more loading in 10 colors and five basics at all. Those days are gone.

Christine Chen - Needham & Company

Did I hear correctly Jim, Madewell is expected to be an $11 million loss? That’s down from the $13 million you previously talked about. Is that correct?

James S. Scully

Yes. We actually started the year at $15 million and then we revised to $13 million. It’s now down to $11 million primarily driven by the performance of the business.

Millard S. Drexler

That’s minor good news here today. But it’s only 10 stores and a rounding error in the company but we’re actually very pleased with what’s going on there believe it or not. That’s a nice little business but it’s small.

Operator

Our next question comes from Richard Jaffe - Stifel Nicolaus & Company, Inc.

Richard Jaffe - Stifel Nicolaus & Company, Inc.

With the direct channel fix guys, I’m wondering if there’s an opportunity particularly in this environment to step on the gas in terms of circulation and email outreach? I haven’t seen a change in the circulation. I’m wondering if there’s a chance to either do more mailers to customers or to reach out a little bit further or deeper into your file to mail more or similarly to use the email channel as well?

James S. Scully

I’d break it into two buckets. In terms of circulation we’re expecting them to be flat for the year. We’re expecting to finish the front half flat. We’re expecting the back half to be flat with some kind of timing issues with being up to about 10% in Q3 and down 10% in Q4. We actually finished Q3 up 8% and we expect to be down low teens in Q4. So we’re going to actually finish the year slightly down.

The focus is profitability. We’re constantly looking at the file and we are mailing to the most profitable segments. So where it would make sense, we will circulate to that. But it’s not just one of those things to flood the homes and expect people to shop. We were I would say pretty surgical about it.

We are driving as much as we can on the web and email. Obviously we’re thinking of all the different ways we can in terms of search and other ideas but we are driving email as much as we can at this point.

Richard Jaffe - Stifel Nicolaus & Company, Inc.

I know there was some disappointment out there with consumers being unable to get to you on the direct channel or get you on a timely basis. Any way to sort of right those wrongs or reach out to them who haven’t maybe been 12 month shoppers because of what happened and maybe their annual shopping spree was postponed for another six months?

James S. Scully

We’ve looked at that but I would say one of the reasons that we broke out the trend for the first two months of the quarter was to highlight the fact that once we did stabilize the platform, the direct business did come back. It was up 21% and we saw that response. But we did see a drop-off in October with that consumer just like we saw with the in-store consumer.

Operator

Our last question comes from Barbara Wyckoff - Buckingham Research Associates.

Barbara Wyckoff - Buckingham Research Associates

Did I hear you allude to the fact that men’s and accessories dropped off about as much as women’s? Did I hear that about right?

James S. Scully

No. I’m not sure. Actually I didn’t hear that part but I’d say men’s was probably a little bit softer than women’s.

Barbara Wyckoff - Buckingham Research Associates

And the accessory business?

Tracy Gardner

They’re commensurate. We’re really not seeing a big decline more so in any other division than another.

Barbara Wyckoff - Buckingham Research Associates

Do you have a sense of how many stores you need at the current run rate in Madewell to break-even?

James S. Scully

I would say that yes we do. We haven’t disclosed that but I would say that a conventional wisdom out there is 40 to 50 units gets you to, depending on the volume, a gross margin at a mature base. I’d say we’re not far off that.

Operator

I’d now like to turn the call back to management for closing remarks.

Millard S. Drexler

Thank you all for joining us. I know it’s not an easy time out there. I just want to assure all our shareholders that every day every one of us is doing the best we can do to figure this out. It just is not an easy time. We come to work with the same passion every day as we did when things were much nicer a year or so ago and much better and more happy.

But I just want to let you know that if there is a solution, if there’s a fix, if there’s thinking out of the box, if there’s creativity, we are working on all of that and we feel the same obligation to our customers as we do to all our shareholders. So we’re working as smart, as hard and as best as we can. We do appreciate feedback. We deal with our customers all day long.

But as we said a few times, it’s hard to predict where things are going. These are somewhat unprecedented times I think we’re all experiencing. We’ll get through this but we wish we knew when. We’re looking forward to those days. I’m sure all of us are.

So we’re here and I just want to wish everyone a happy and healthy holiday season. We look forward to speaking to you in March I think. Anyway, have a good Thanksgiving everyone. Thank you.

Operator

This concludes the teleconference. You may disconnect your lines at this time. Thank you for your participation.

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