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Executives

Allison Malkin - Integrated Corporate Relations

Millard S. Drexler - Chief Executive Officer

James S. Scully - Chief Financial Officer

Analysts

Paul Lejuez - Credit Suisse

Kimberly Greenberger - Citigroup

Michelle Tan - Goldman Sachs

Brian Tunick - J.P. Morgan

Randal Konik - Jefferies & Co.

Richard Jaffe - Stifel Nicolaus & Company, Inc.

Christine Chen - Needham & Company

Laura Champine - Cowen & Co.

Robert Samuels – Oppenheimer & Co.

Stacy Pak – SP Research

Dana Telsey - Telsey Advisory Group

Marni Shapiro – Retail Tracker

Janet Kloppenburg – JJK Research

Beth Lilly - Gabelli Funds

J. Crew Group, Inc. (JCG) F4Q08 Earnings Call March 10, 2009 4:30 PM ET

Operator

Welcome to the J. Crew Group, Inc. fourth quarter and fiscal 2008 results 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

Good afternoon and welcome. 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.

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

Millard S. Drexler

Good afternoon and thanks for joining us. Jim Scully, our CFO, is here along with Tracy Gardner, President of Retail and Direct, and other senior partners at the company. I will begin with a brief overview and then Jim will cover our financials in more detail and update our outlook for 2009. We are in fact going to keep this short as we know there are a lot of questions.

We are disappointed with our fourth quarter operating results. While the retail environment is obviously being severely impacted in this economy there are things we could have done better. Our mission day after day is to adjust to this new, not fun retail reality, while not compromising our long-term strategy and integrity.

In the short term we are micro managing every aspect of the business and making critical decisions that go with the territory, which include our recent announcement of a cost reduction program. We are extremely focused on maintaining a healthy balance sheet.

We ended the year with $146.0 million in cash and no revolver borrowings. We have reduced our new store openings, we plan to open 25 new stores in 2009 versus 42 in 2008. This represents a 40% reduction in both new square footage and new units.

And importantly, our inventory management, our priority in the fourth quarter, was to clear our fall and holiday inventory and we are pleased that we began 2009 with less fall and holiday product than last year.

We will have inventory growth in line with the current trend of our business by the end of the second quarter. Despite the world around us, we are really excited by the way our product catalogue and our stores look. We are working very hard every day to do the best we can do with what we think is really great product and we are getting great feedback to that effect every day, which by the way, to us, is really the most important measure.

We are traveling to our stores and listening to our customers as always and catering to their needs. There is a change in the business. Customers are more hesitant to spend and are shopping differently. Based on what we see, hear, and feel every day, we are making changes in the mix of our assortments.

In this kind of environment in order to stand out and service the needs of our customers, we need to be more creative than ever in our products, our stores, catalogues, and our website.

And finally, regarding Madewell, we continue to be very pleased with the business. We experienced an operating loss of $11.0 million in 2008 in which matched our improved expectations. We currently operate 13 Madewell stores. We most recently opened on Newbury Street in Boston and Greenwich, Connecticut earlier this month. We plan to open a total of 8 new stores in 2009.

We cannot predict the future and forecast in this environment as it continues to be extremely difficult. All we can do is stay focused on our mission and remember we are in it for the long term.

Our outlook, which Jim will review in more detail, contemplates the current trend of our business, our current spring and summer inventory purchases, and our cost structure initiatives.

With that, I will turn the call over to Jim to review our fourth quarter and year end results and our outlook in more detail.

James S. Scully

Turning to the details for the fourth quarter, total revenues decreased 3% in the fourth quarter to $388.0 million. Our store sales, which include our retail, factory, Crewcuts, and Madewell stores, decreased 3% to $252.0 million. This decrease was driven by a 13% decrease in comp store sales, partially offset by a net square footage increase of 10%.

Our direct business experienced a 2% decline to $123.0 million on top of an 11% increase last year.

While we largely stabilized our direct system’s infrastructure during the third quarter, we still experienced site delays and down time during our peak season, which negatively impacted our fourth quarter direct results.

We have not experienced any direct website issues since the end of January and we continue to work every day to ensure we deliver high quality experience to our customers.

Gross profit dollars for the fourth quarter were down 35% to last year. Gross profit margin declined to 27.6% versus 41.3% last year with the merchandise margin declining to 38.6% versus 51.3% last year.

This was coupled with 100 basis points of buying and occupancy deleverage. The merchandise margin deterioration resulted from first entering the fourth quarter with inventory per square foot 9% over last year and AUR compression as a result of the competitive environment in our sales trend. Our buying and occupancy deleverage resulted from rent expense increases primarily from new store openings partially offset by reductions in buying costs versus last year.

SG&A expenses for the fourth quarter increased 5% to $127.0 million with 32.8% of revenues versus 30.4% of revenues last year. The fourth quarter included approximately $3.0 million in incremental costs related to the direct systems stabilization efforts. These costs represent 80 basis points in deterioration.

In addition, the fourth quarter SG&A included a non-cash asset impairment charge of approximately $2.0 million related to underperforming stores which were not contemplated in our fourth quarter guidance.

And finally, we experienced a decrease of approximately $4.0 million related to share based and incentive compensation expense in the fourth quarter versus last year. As a result, we experienced an operating loss of $20.0 million which compares to operating income of $43.0 million last year.

Net interest expense for the fourth quarter totaled $1.6 million compared to net interest expense of $1.8 million in the fourth quarter of last year. The decline in interest expense primarily reflects our lower outstanding debt and lower interest rates related to the term loan.

Our net loss for the quarter was $14.0 million, or $0.22 per share, compared to net income of $25.0 million, or $0.39 per share, in the fourth quarter last year.

For fiscal year 2008 total revenues increased 7% to $1.4 billion on top of a 16% increase last year. Our store sales increased 7% to $974.0 million. This increase was driven by a 10% increase in our square footage, partially offset by a 4% decrease in comp store sales.

Our direct business experienced an 8% increase to $409.0 million on top of a 22% increase last year.

Gross margin deterioration of 520 basis points resulting from aggressive markdown activity, primarily in the fourth quarter, coupled with 90 basis points of SG&A deleverage, drove the deterioration and our operating margin to 6.8% versus 12.9% last year. This operating margin includes an $11.0 million loss associated with Madewell.

Turning to key balance sheet highlights. Cash and cash equivalents were $146.0 million at the end of the year compared to $132.0 million last year and include voluntary principal payments of debt of $25.0 million during the last 12 months.

As a reminder, in addition to our growing cash position, we have a $200.0 million working capital facility which matures in 2013 that we have not borrowed against in the last five years. As long as we maintain excess availability of $20.0 million, we have no financial covenants with regard to this facility. At the end of the fourth quarter excess availability was $192.0 million.

Inventories at the end of the fourth quarter were $187.0 million, representing an 18% increase over last year and a 7% increase on a per square foot basis. We are pleased with our fall and holiday inventory levels at the end of the fourth quarter which sit below last year’s levels and are lower than we had anticipated.

As we have said previously, the sales trend of our business sits well below what we had contemplated when we placed our spring and summer inventory purchases. As a result, we will expect significant margin pressure in the first half of 2009, which is contemplated in our first half outlook.

Capital expenditures for the fourth quarter were $18.0 million and $78.0 million for the full year, slightly below our guidance of $80.0 million.

Turning to the outlook, given the continuing macroeconomic uncertainty we are suspending annual EPS guidance. However, consistent with our current practice, we will continue to provide EPS guidance on a quarter-by-quarter basis. We will also provide additional guidance on selected controllables for the full year. We have based our first quarter guidance on fourth quarter trends and our assumption is for this environment to continue.

For the first quarter we expect diluted earnings per share in the range or $0.07 to $0.12, which compares to $0.48 in the first quarter of fiscal 2008. Our first quarter outlook reflects comp store sales in the negative mid-to-high teens, a direct sales decline in the mid-to-high single digits, and gross margin deterioration of approximately 800 basis points.

We expect inventory per square foot at the end of the first quarter to be relatively consistent with where we ended the fourth quarter. At the end of the second quarter we anticipate our inventory per square foot growth will be aligned with the current sales trend of our business.

Clearing through the spring and summer inventory will result in second quarter year-over-year gross margin deterioration similar to our first quarter guidance.

For the full year, based on the current trend, we expect SG&A dollars to be relatively flat versus last year. Slightly higher in the first half and slightly lower in the back half with a 5% to 10% reduction in SG&A dollars per average square foot for the full year.

This reflects the anticipated savings of approximately $40.0 million on an annualized basis from the cost reduction program we recently announced, which included a 10% headcount reduction, the suspension of the 401K plan company match, elimination of the 2009 merit-based wage increases, and other company-wide reduction programs such as supply chain, store operations, real estate, and catalogue circulation.

Annual net square footage will grow approximately 5% and 4%, excluding Madewell. We have plans to open 25 new stores in 2009 which include 7 retail, 6 factory, 4 Crewcuts, and 8 new Madewell locations.

Capital expenditures for the full year will be approximately $55.0 million with depreciation and amortization of approximately $52.0 million.

We are assuming an effective tax rate of approximately 40% and approximately 66.0 million diluted shares outstanding for the full year.

And now I will turn the call back to Mickey.

Millard S. Drexler

As we look forward into 2009 we have taken some necessary steps to reduce our expense structure and we will continue to stay focused on our vision and execution providing our customers with the best we can in quality, style, and design.

Now we are ready for questions.

Question-and-Answer Session

Operator

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

Paul Lejuez - Credit Suisse

Just wondering how far out you’ve already placed orders for your inventory, or have you already placed orders for fall.

And on the direct business, just wondering if you can talk about how you’re planning circulation throughout the year in terms of number of catalogues versus 2008, the breadth of distribution, and the number of pages.

James S. Scully

In terms of inventory purchases, we are bought for Q3 at this point.

And turning to circulation, we finished last year down 3% in circulation. And this year we were planning Q4 down 10% and it came in down 18% in Q4. As we have said, we are constantly testing our efforts in circulation, and in Q3 and in Q4 we completed some important tests and we are very pleased with the results so we’re going to implement these in 2009. So these efforts, I think, will allow us to keep circulation and trend consistent with where we were in Q4, which is down 18% for the year, and I think we will continue to give you updates throughout the year as we go forward.

Paul Lejuez - Credit Suisse

And when you say circulation you’re talking number of catalogues mailed?

James S. Scully

I’m talking pages circulated.

Paul Lejuez - Credit Suisse

Total pages?

James S. Scully

Yes.

Paul Lejuez - Credit Suisse

And on that inventory, your answer there, so are we to assume that you’ve bought third quarter inventory down in line with where comps are currently running?

James S. Scully

What we’ve said so far, is what we said in my prepared remarks, which was at the end of Q1 we will see inventory per square foot up consistent with where we were at the end of Q4. At the end of Q2 you will see inventory per square foot consistent or aligned with where we see the sales are today. So the answer to your question is yes, at the end of Q2.

Operator

Your next question comes from Kimberly Greenberger – Citigroup.

Kimberly Greenberger - Citigroup

I was hoping you could address your pricing strategy for this year. Any efforts to maybe fortify your opening price points in the assortment, and when should we see that fully reflected.

And are there any required debt payments in 2009, since you were prepaying last year.

James S. Scully

As to required debt payments in 2009, last year we made a voluntary payment of $25.075 million. Before that we do not have any mandatory payments in 2009.

Millard S. Drexler

As to pricing strategy, we’ve done it. If you go to the store and shop it and compare it to what was, you will see our knits, our pants, key items under $80 to $90 retails in a lot of cases have been adjusted. We have more inventory than we did a year ago below $80, below $50. So that’s actually in the assortments now. It’s been in there since the quarter because we started looking at that clearly when the customers stopped buying at higher levels three, four, five months ago.

So you should see that. It’s a continuous evaluation of where the price points are. Non-apparel same thing. And we are clearly going to where the customer is going. We are trying to get there a little before they are at this point and we are still playing a fashion/style/value game. We are not going to take price points to the point where, as someone said to me today, “Why aren’t your cashmere sweaters as cheap as so-and-so’s?” Even though their quality is not as good and their fit is not as good? And I said, “You’ve just answered the question.”

But that being said, we are totally on it, where we have to be. And you will see going forward our investments on price points skew lower from a mix point of view than they have before.

Operator

Your next question comes from Michelle Tan - Goldman Sachs.

Michelle Tan - Goldman Sachs

I was wondering if you could give us clarity on a couple of things. On the gross margin for first quarter, given that sales are not expected to improve and the inventory level is coming in as roughly where it was in the fourth quarter, what is the driver of the better merchandise margin performance in Q1?

And then secondly, what kind of upward pressures are there on SG&A that will be a partial offset to the cost savings program?

James S. Scully

First, as it relates to the gross margin, we suffered. I said it was 1400 basis points in Q4. We did come in at 9% per square foot so we are leaving at 7% per square foot, so there is an improved position.

Really, the shoe fell late in the quarter. It was really September, October when we saw the drop-off in the trend. We had a limited period until Christmas to clear through the inventory.

The different story here is we have the full first half in front of us so we have an opportunity to stretch inventory from Q1 into Q2, as we said, we talked about, on a half. And we took some actions on it as well, throughout the first half.

With respect to the SG&A, some of the upward pressure that we had, the biggest upward pressure we have is in depreciation. It’s new store expense coming in from the openings last year. And then we continue to have some upward pressure just due to FAS 123R and stock expense.

In addition, last year we didn’t have really incentive bonus expense because we didn’t hit our internal targets. We do have that pressure and we add that back in at target 4 of 2009.

Operator

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

Brian Tunick - J.P. Morgan

What is the final tally of the website disruption expenses. I think Q2 through Q4, I think we’re thinking $11.0 million or $12.0 million. Is it fair to think you should recover most of that? And maybe you could talk about how you think about clearance. Either as we saw in the fourth quarter or next year, between the website, the full-price stores, and factory, what is your philosophy on clearing?

James S. Scully

On the expenses, it is $12.0 million. In terms of the ability next year to go against that, I think the important things is what I said to Michelle, we didn’t have bonus expense or incentive comp last year so that was almost offset the $12.0 million that we had related to the direct infrastructure. It’s a little skewed by quarter but for the year it’s the same amount. So we won’t repeat one but we’ve got to put the incentive comp back in.

Millard S. Drexler

As to clearance, fourth quarter was quite extraordinary in the clearance pressures we all had. Not just us, I assume. We are actually back to our normal, take mark downs when they should be taken, keep an eye on the inventories. We have added a sample sale, local New York sample sale, on samples which we actually did quite well on, but otherwise the key now is controlling inventory and not overbuying. Buying to trend.

Now, of course, buying to trend is easily said, so we’re doing that. We hope we are terribly wrong on that but we are being very conservative. But we are taking back to normal on markdowns. If you go to our stores and to our website you will not see the punishing low-price markdowns that we had to move in fourth quarter to eliminate old, excess inventory.

So that’s where we are right now.

Operator

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

Randal Konik - Jefferies & Co.

You gave a little color on the direct business. Can you just go over where you are with the logistics of that. You said there were no more problems in January. Have there been any more IT initiatives on that side of the fence?

And on the real estate, it looks like 30% of your growth for 2009 is coming from Madewell. Can you give us an update on what you’re expecting the losses to be?

And can you clarify, I think for SG&A dollars for 2009, I think you said flat. Can you just clarify that?

James S. Scully

The easy one is on SG&A, it was flat dollars for the year. Slightly higher in the front half and slightly lower in the second half.

With respect to the System 7 direct business, I think while we are pleased with the progress we made stabilizing the operations in systems, we are clearly disappointed with our site performance in Q4. We continue to experience instability on high volume days, which led to poor customer experience and business interruptions throughout Q4. We have made several changes internally to address the performance issues and we have seen some improvement.

As I mentioned earlier, we have not experienced any issues since the end of January. While this is not a heavy traffic period, we have had days where we have experienced traffic levels which would have caused problems in the past. So that has been a positive improvement.

And finally, we are currently working through a very detailed and comprehensive process on the performance testing side, with some external experts to ensure that we are ready for peak this year.

And with respect to Madewell, the Madewell loss we are estimating for 2009 is $15.0 million to $16.0 million which compares to the $11.0 million last year. I would say it’s split 50/50 in terms of the increase. Half of it relates to store expenses for the annualization of stores opened last year and new stores opening this year, and the other half relates to the launch of Madewell.com.

Operator

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

Richard Jaffe - Stifel Nicolaus & Company, Inc.

You referred to inventory plan following the trend, has there been some increase in the ability to work a little closer if the trend improves? Are you in the position to chase things as the second half approaches? And to manage inventories after Q2 to a more optimistic level?

Millard S. Drexler

Yes, we are. We have positions on certain fabrics, knits, certain wovens. We are just being incredibly conservative right now. The creative process is about nine months but the actually manufacturing process is four to five months. So the answer is yes.

We also have strong relationships with our factories. You know, we kind of have less is more. But our outlook has been, frankly, now we would rather chase than not and if we can’t get it, we would rather not get it than have too much inventory because none of us really have figured out where this thing is going, where is the bottom, where is it settling in at.

We do know for sure that there is enormous price sensitivity out there. We know that newness is selling. We know that novelty is selling well. Commodity businesses, which fortunately we’re not in that much these days, are more challenging.

So we are just being real conservative now and we will respond, as we are today, on some accessory and non-apparel categories as we are knits, etc.

Richard Jaffe - Stifel Nicolaus & Company, Inc.

Did you comment on circulation for the year? Page count down or total books down?

James S. Scully

Yes, we said for the year, the trend in Q4 was about down 18% and we said that would hold true for 2009 as well. High teens.

Operator

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

Christine Chen - Needham & Company

I think you said in the past that when the fashion is there the customer is still buying. Are you still seeing that or are you seeing her trend more towards the basics business.

And I was wondering if you could comment on how much of impact on IME the sharper price points are having.

Millard S. Drexler

During normal time, and there’s no normal now, it’s the new normal, people are in fact buying fashion. I would say the last thing we would want to own is basics, right now, that look like other people’s goods. That, frankly, becomes a price gain, a commodity gain, and we will never be the lowest cost or the lowest retailer, seller around.

But we, if you look at our assortments, and I did mention, by the way, and I think this is really important, you know all the other things we are doing now are critically related to the assortment. We have not moved off long-term objectives, except we have adjusted prices. We are skewing inventories at much more friendly prices and our opening price points are sharper.

That being said, because of lower costs right now, which is clearly less demand, lower costs, you know, it happens to us and it happens to the factories. Same thing, they’re dealing with the same huge cutback in orders from around the world. So we are actually maintaining initial margins in that regard.

Christine Chen - Needham & Company

Would you say that as you move towards fall your mix will be skewed more heavily towards fashion versus basics?

Millard S. Drexler

I hate the word basic. I think our company is about style. I saw a woman today who was the most stylish woman in the world. Not the most, that’s a little exaggeration, but she was so there with the right things and she was wearing a basic white T-shirt, so I think if you look at our T-shirt assortment today and you look at the ruffles, you look at the novelty, and I think it’s true throughout our business, we don’t want to be in the commodity business that looks like everyone else’s goods.

Now, that being said, our best selling T-shirts might have a different shape, they might have a new fabric, they might have a different vee, they will have a different detail, but the days of basic means the days of selling it cheaper than the competition. The customer is smart, they’re quick, and frankly, the game and the hobby now is to spend less than more on everything you’re buying.

So you’ll see for spring, for fall, continued fashion for summer fashion, but it’s commercial, it’s cool. I don’t want to say it but I heard it today from some critics of ours, some critical customers, who said, “J. Crews is a store you can still buy a lot of clothes without becoming poor and with looking terrific.”

And you know, if our business were only as good as our buzz and feedback throughout every shopping center, we would be very happy and having fun. But that’s what we’re working towards and I think we’re as well positioned as we could be if and when things start to move forward and turn around.

Operator

Your next question comes from Laura Champine - Cowen & Co.

Laura Champine - Cowen & Co.

I heard 66.0 million diluted shares outstanding. Was that the year end expected share count or is that an average?

And secondly, if you can carve out the same store sales number for Q4 in terms of transaction decline and ticket size decline, that would be helpful.

James S. Scully

It’s 66.0 million diluted shares for the entire year. That’s an average for the entire year.

And with respect to the comp components, we have never broken out the comp components for Q4. I will say that I talked about in my comments, in terms of gross margin, it was really an AUR story, as we had to mark down and clear the inventory in Q4.

Operator

Your next question comes from Robert Samuels – Oppenheimer & Co.

Robert Samuels – Oppenheimer & Co.

Can you just give us a sense of what you’re currently seeing with regards to the consumer environment. Is there anything out there that is getting you excited about the back half of the year? Specifically with holiday weather, trend-wise, some new fashion. Just what you’re seeing would be great.

Millard S. Drexler

No, I’m seeing it kind of sucks, you know. Saturday was an interesting day. It was warm weather around the East Coast. I got a few calls from some of my friends, friends in misery or whatever, “Hey, we had a nice day today. And then it went back to normal by Monday.” I think what we’re seeing is you can’t really figure out. We’re moving one foot in front of the other, we’re playing offense as well as defense here, but I can’t tell you. The only thing I know is that our best sellers are things that are in fact stylish, they’re fashion, they are well priced, they are under $80 and $90, and that’s where the action is right now.

And our knit business, our woven shirt business, I think the customers—and accessories. I think when they go in right now, if it’s fun, affordable, it’s under $100, and they’re going to buy it.

Now, that being said, the wedding business is good because you get married you want to buy bridesmaid’s dresses. Our men’s suit business is good. And our women’s suit business is good. Because I guess you need that to go to work or in these days, to look for a new job. Jewelry. So I can’t tell you that there’s been a week or two where we got—like my friend on Saturday, who runs a company. Said, “I think the turn is here.” Then I spoke to him today, “The turn ended.”

And I think that’s what we’re facing right now. I wish I had a better answer and I wish we could see the road map more clearly. It’s just not the case.

Operator

Your next question comes from Stacy Pak – SP Research.

Stacy Pak – SP Research

Can you comment on what fashion trends you may be excited by for this season and into next? And also, can you give us more detail on Madewell, just the progress there, what you’re seeing, how you’re feeling, etc?

Millard S. Drexler

On fashion trends, some things I won’t talk about, for obvious reasons. Other things, and you know there’s things we’re working on fall right now that we’re really excited about that we’re really excited about and I think the key for us is continuing to differentiate between us and what’s out there. I think we have good opportunity because I’m looking at the landscape and I don’t see the most exciting landscape out there these days. I think we clearly have opportunity on price point versus high price designer clothes, and if I look at the comps I see that.

If we could provide fashion at what we consider good value, and you know, we’ve been a little bit of a broken record on this now for six months. It’s clear when you look at the compass out there, the higher the prices the more challenging it is.

We are finding that in the context of our own business. People are incredibly careful about spending money today. So I actually like that opportunity.

Now there’s the low price guys that might be taking it from the medium-price men and women and might be taking it from the high price, but it’s about fashion. That’s commercial. Now I go through the designer stores and I go through all the shops. We all do. We’re out there every day or two, and if the clothes are not comfortable, wearable, and this is only our personal opinion, and they can be worn more than one day without thinking they’re going to be obsolete, I think we have a real benefit.

And our clothes are kind of tested in the regard that we like to think they get put in the closet and they are worn multiple times, and they go with last year’s wardrobe, they go with this year’s wardrobe, etc., etc.

But again, it’s novelty, it’s pretty, it’s roughly right now. And it’s also great shaped T-shirts with the right vee or the right crew in men’s and women’s. It’s a new fabric in men’s and women’s T-shirts that we developed.

Of course, all along with the right price. It takes it all. And we are trying to maintain the integrity of our pricing. You know, I think the Christmas thing fortunately was not for us. Fourth quarter was how low can it go and it was almost embarrassing what a lot of us were selling goods for.

But I think we’ve kind of gotten over that hump but they are clearly saying, “I want value at any price.” And I think that’s going to be the continuing game. We said there is reset button pushed and we’re playing with the reset button. If it changes, we will change.

Regarding Madewell, it’s an interesting business. We have 12 or 13 stores, we’re opening the 14th tomorrow in Los Angeles. We’re really please with the positioning. It’s an age, price, value, and product game. It’s a focused business. It’s not in the multiple lifestyle assortment business J. Crew is in. We keep reinforcing our denim, our knit business, our boot business during the fall, our accessory business.

You know we’re probably as famous for scarves as anyone in the world is right now. You see it, you feel it. We are working very much on pricing there but the nice thing about the business is that the prices, and it was kind of what we felt we needed, was friendly good value but with great denim, great fit. So we’re finding that. We just introduced the structured jeans, at whatever price, over $165, $175, they’re selling. And we’re moving into a friendlier jeans prices this fall, below where we begin now. We basically begin at $92.50 right now and we’re moving into probably a $20 or so point less than that.

We see a nice opportunity for the graduates of all those great teenage companies. We see a point of view in the store that we don’t see from our competitors. And by the way, when the competitors have it, there’s got to be a reason for us to be, but I think the design, the feel of our stores, we opened up in Newbury Street in Boston, in Loeb’s Stable, we open in Greenwich Avenue.

You know, we don’t like losing the money. It’s the price we pay for long term. But as I said, we’ve been on plan there and we’re kind of pleased. Of course, in this marketplace we’ve slowed down a bit on where we’re going to take it, because you know, I don’t know how much any of us are getting paid for new real estate. I am not sure the reality has struck some of our landlords on the values out there because if prices are down, costs are down, Hello? Rents should be down also.

So we’re being incredibly selective. And under the new reset button, we’re being more conservative in forecasting sales and therefore more conservative in what kind of rents we want to pay.

So we’re just sitting back. Again, balance sheet priorities, cash, and when we spend it we want to spend it where we see opportunities. So we are being conservative. But by and large, again it gets back to customers’ emotional response. People really like Madewell and the numbers, relatively speaking, have shown that.

Stacy Pak – SP Research

What did you find for the Shop Bop partnership? Anything interesting there?

Millard S. Drexler

Yes. We’re selling, actually very interesting. For two things. One, that is stuff we do for exposure. It’s amazing when you get a very prestigious hip brand like Shop Bop selling Madewell. We are selling the goods really well. The best number was our little short overall at $165. It kind of blew me away and blew us away. And we are selling it at our stores, also.

And I think it’s all about validation. Shop Bop validates us. Designer jeans sometimes get validated by high-priced celebrities who get paid or wear their jeans, etc. So that’s really been helpful. And it’s getting the word out.

Remember, Madewell—I do my own surveys downtown, wherever I am. Most people never heard of Madewell. I was as Balcazar this morning asking a few people, three blocks away. Actually three blocks. Half the people, women, never heard to it. Because it’s not online yet, it’s pretty much unknown. So we keep working that. And it’s a slow thing but we actually like it a lot. We like where it’s going. We like the mixes a lot. And I think we have a nice denim option. Still, it’s a work in progress.

Operator

Your next question comes from Dana Telsey - Telsey Advisory Group.

Dana Telsey - Telsey Advisory Group

Could you talk a little about the factory business and how that differs or is similar from the trends you’re seeing in the regular price business, either in terms of unit or product-wise, anything different.

And then, in terms of the cost-cutting initiative, besides people, what other advancements have you made. There’s real estate and opportunity. What are you seeing there?

James S. Scully

As to the cost-cutting initiative, if you look at the $40.0 million expense initiative, the 10% headcount reduction was really about 25% at about $10.0 million. The real big opportunity came from things I talked about. Circulation was a big opportunity. Supply chain, we negotiated contracts on both sides of the ocean, as well as efficiencies built in our DCs and our call center. Those are the big ones.

We are obviously going after every other area as well, whether it’s travel, supplies, but the big ones that I just mentioned.

Millard S. Drexler

Factory business, we are very pleased. We don’t separate comps. It’s all in line with where the consumer’s mind set is. And I know there has been some thoughts, and we’re not seeing that, that if in fact the stores are all on sale—and a lot of stores, by the way, are on sale in the regional malls, etc.—that it might hurt factory.

What we have actually seen is, and I don’t want to sound like partial to our assortments, but we haven’t held back on being as good as we can be in factory, but I think when you go to the factory centers, it’s kind of a new part of the reset button. You go to the factories, you’re guaranteed to get value with more—again, personal opinion—it’s easier to shop. Every store is on sale, whatever it is. But we’re actually quite pleased with factory. It’s going well.

Operator

Your next question comes from Marni Shapiro – Retail Tracker.

Marni Shapiro – Retail Tracker

I don’t know if you talked at all about metrics and if you could talk about traffic versus conversion. I know they’re kind of muddy because of the sales that have been going on but anything you can glean from that.

And just on the product side, a little bit more color, I guess, there are so many copycats out there. You know, you’re ruffled jacket cardigan is all over the mall. And so this is the kind of environment where it seems she’s reacting to what’s emotional in the mall, what’s really catching her eye and she feels like she has to have. And you’re not getting paid to do what everyone else is doing. So do you feel like you’re ahead of the pack at this point and are you able to take some real out-of-bounds test and ideas with design that can keep you really two steps or three steps ahead of everybody?

James S. Scully

In terms of the metrics, we really don’t break out the comp metrics. What I did do is point to the comment made in the prepared remarks, which was in Q4 we did see a significant decline in AUR, just given the markdown activity.

Millard S. Drexler

Here’s my answer on that. There has never been a time in the apparel world that people aren’t copying people. It’s a given. In my old company everyone was copying them when they were hot and then the new business opened, Old Navy, and then they started copying them when they were hot.

Here’s how we look at it. It’s about the integrity of your product more than ever today. What we see happening, and again, personal opinion, is high integrity businesses, high integrity brands, that have quality in their product and treat their customers with respect—and look, I see windows where they look like our windows from last year. One of our competitors does exactly what our color assortment is. I find it embarrassing.

And you know something. If you are a cheap discounter, discounters do it every day, customers who buy know value. And the sweater you’re talking about, it’s funny, because when I was in Balcazar this morning one of the waitresses was wearing another well-known marketer. She says, “There’s your sweater. I love J. Crew.” You build a confidence in a brand.

I don’t see people, if they’re being treated well, trading down. They might buy less. They are. They might be buying less units, but we go on to the next. And you know something, that’s it. And for us, sure, yeah, you get a little ruffled. And we all have egos and we all know we’re looking at everyone else closely but the ones that are copying, and anytime I’ve copied in my life, you lose your track, you lose your point of view.

Customers know. They want to go into a store that’s like a painting. It’s painted well, it’s on a canvas and has a point of view. Not one that’s copying everything except fast fashion, although most of them, I think, have good points of view.

So that’s what it is. I hope I’m not sounding defensive on that one but I have to say, we live with it, I’ve lived with it for many decades, and my blood boils a little. It’s okay. And then you go on to the next.

I think right now, and we just had this discussion today here, you know, we have these partnerships with certain brands and J. Crew and Madewell. It is amazing what’s going on today with integrity brands in the world. They become more and more important to a consumer than a blindly priced private-label item today. There is a lot of integrity with business that has been around a long time. And for us, we only reinforce it with 24/7 commitment to our quality and our product and you want to speak to any of us, we are available on the phone to discuss anything and everything.

That being said, Jen is in Europe right now, Ken is in Japan. We are doing worldwide research. We’ve got to be on to the next. And that is always the game we’re in.

Operator

Your next question comes from Janet Kloppenburg – JJK Research.

Janet Kloppenburg – JJK Research

I was wondering if you could talk a little about what’s happening on the product cost side? We’re hearing a lot about excess capacity at a lot of the Far Eastern manufacturing plants. And we are wondering if that’s going to be working in your advantage as we walk into the fall season.

And I was also wondering if you could talk a little about your special occasion business. You mentioned that it was doing well. Is that a business that you will be investing in going forward or will that be a business that you’re happy with the level it’s at?

And can you tell us why the share count is so high?

James S. Scully

The share count may seem high because Q4 was based on basic shares. And we’re talking diluted next year.

And with the unit costs, we do see unit costs coming down in the second half of the year. Just from the sourcing raw materials and also the waiver and also things we are doing with our manufacture partners as well.

So we saw increases last year. We talked about those coming into the second half of last year. We have felt those through the first half of this year, but we will see that trend reverse in the second half of this year.

Janet Kloppenburg – JJK Research

And will you pass that on?

James S. Scully

Yes.

Millard S. Drexler

With balance, of course. We pass on and it depends on quantities purchased, investment and creativity of the product, so on and so forth.

You meant special occasion instead of social, right?

Janet Kloppenburg – JJK Research

Right.

Millard S. Drexler

That business is very strong. It’s been terrific. We’re trying to figure out the expansion strategy for it now. Certain stores will carry it. We are on that and it’s very good and we know it could be bigger but we, again, are being conservative right now.

Operator

Your next question comes from Beth Lilly - Gabelli Funds.

Beth Lilly - Gabelli Funds

I had a question about Madewell, can you help me? There’s two things. Can you expound a bit more on the positioning of Madewell, the brand, and how your point of view is different than the competition. What is it that you are doing with Madewell that your competition isn’t doing?

Millard S. Drexler

Well, I would have to ask you because you’re a customer. Look, here’s what it is. You can buy anything in any store in the world because everyone carries clothes. There is no need for another clothing store. I do think there is a need for a clothing store that carries great fitting jeans for $100, not $150 to $200, in a specialized environment.

Now you know, I always think specialists do things better than generalists although clearly the department stores do a nice job in designer jeans because they carry everyone and everything. But as I look at our jeans assortment, I look at the pricing, I look at the fit—our rail straight, our bootlegger, our skinny low, they’re all jeans that we’re reinforcing now.

This is a very new company so no one knows about it. I go into the stores as a consumer, not as the merchant who has a prejudiced opinion, and I look. By the way, every store we look at we look at critically to see what we can do better. I think the T-shirt assortment is arguable one of the best T-shirt assortments, arguable I said, in America. It doesn’t have logos, it’s not only graphics, and if you go to Greenwich, Connecticut, or Newbury Street and all those stores, you’ll see tons of mothers and daughters buying jeans, T-shirts, our grandfather sweaters. And by the way, I might add, look at the pricing.

I love some of our competitors, they’re good friends of mine, but I went through their stores and looked at the price of T-shirts. Other than our friend who is a cheap T-shirt seller, it’s stunning to look at what fashion T-shirts sell for outside of J. Crew and Madewell.

I think a $35 T-shirt ought to be $35, not $70, but there’s two profits in between there. I also think that our high-price T-shirt competitor shouldn’t be supporting factory stores or the discounters outside of the stores.

So we go in there, it’s very simple. We make goods, we take our fair share markup, we have a very creative team, and as we look at Madewell, now again, I probably am partial here, I don’t see environments out there that a jean-based business in specialty stores selling to a 21-year old and above that have high integrity jeans, T-shirts, scarf assortments, Italian boots at $200 to $400, and specialized, it’s a high-low business.

And we do with our only competitors now. Of course, you can buy everything any of else sells anywhere at any store, sometimes at any price. The other irony, by the way, is in today’s marketplace on price is all of us go online. It’s a game I play personally. I see a price in the store, it might not be apparel. It happened last week with one of the famous department stores, sold something that I happened to buy. I said, “Well, you know, this seems like a high price.” I go online. Hello? 35% less. Ordered it.

Now, I find that in today’s marketplace a big elephant in the room. You cannot find our goods on sale anywhere except in stores we control or on e-bay. And so whatever, I’m a believer. It’s a long answer to a question but big believer, when you control your distribution you control your product. Apple stores are a perfect example. And then you’re controlling your destiny and where you take it.

I find the discounters selling every product that everyone else sells in America today. I find it incredibly ironic. So we have a game in our company, go online and find out the real price.

I don’t know it that answers Madewell, but it’s a little point of view on the rest of the world. But we like Madewell, the customers like it, and whatever.

I know I got carried away with that answer.

Beth Lilly - Gabelli Funds

No, no. That’s helpful. Because I shop the stores and I’m trying to figure out, I’ve seen the stores and I’m trying to figure out what’s your target.

Millard S. Drexler

Well, you’ve got to meet me in the store then, okay?

Beth Lilly - Gabelli Funds

All right. You’ve got a deal.

My next question is, your losses are accelerating, of course, which makes sense, but at what point do we start to see the losses diminish?

James S. Scully

That’s dependent upon the roll out strategy. So, as we’ve talked in the past, we put the target out there, a critical mass of 40 to 50 stores, when we see the losses churn to a break even, possibly even profitability, due to some leverage that we get on the gross margins as well as the expense structure. So the fact that we have slowed growth a little bit going into 2009 will delay that. But as Mickey said, that’s more because we want to take advantage of what we think in the future will be better rent deals.

Operator

That is all the time we have for taking questions.

Millard S. Drexler

Thanks for joining us and we will be speaking to you on our first quarter results in May.

Operator

This concludes today’s conference call.

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Source: J. Crew Group, Inc. F4Q08 (Qtr End 01/31/09) Earnings Call Transcript
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