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The Gymboree Corporation (NASDAQ:GYMB)

Q4 2008 Earnings Call Transcript

March 4, 2009 4:30 pm ET

Executives

Jeff Harris – Vice President of Finance

Matt McCauley – Chairman and CEO

Kip Garcia – President

Blair Lambert – COO and CFO

Analysts

Betty Chen – Wedbush Morgan

Brian Tunick – JPMorgan

Rick Patel – Bank of America/Merrill Lynch

John Zolidis – Buckingham Research

Tom Filandro – SIG

Adrienne Tennant – FBR

Margaret Whitfield – Sterne, Agee Capital

Linda Tsai – MKM Partners

Stacy Pak – SP Research

Marni Shapiro – The Retail Tracker

Janet Kloppenburg – JJK Research

Bill Dezellem – Tieton Capital Management

Rob Wilson – Tiburon Research

Operator

Good afternoon. My name is Christy, and I will be your conference operator today. At this time, I would like to welcome everyone to the Gymboree Corporation fourth-quarter 2008 earnings call. (Operator instructions).

Thank you. Mr. Harris, you may begin your conference.

Jeff Harris

Thank you very much, Christy. Welcome to the Gymboree Corporation's fourth-quarter and full-year 2008 earnings call. I'm Jeff Harris, Vice President of Finance for Gymboree.

On the call with me today are Matt McCauley, Chairman and CEO; Kip Garcia, President, and Blair Lambert, COO and CFO. Matt will start off with a few comments on the current state of business and some specific issues impacting the coming year. Blair will then make a few comments about our fourth-quarter financial performance and plans for 2009. Kip will discuss product performance for the fourth quarter and our merchandising initiatives for 2009. Matt will then wrap up the presentation.

After everyone has completed their prepared remarks, we will all be happy to take your questions.

I want to point out that our presentation today contains forward-looking statements, including statements about trends and operations, future sales expectations and future financial performance. Actual results could differ materially from those forecast as a result of a number of factors, including those set forth on our Form 10-K for the year ended February 2, 2008 filed with the SEC.

I would also like to point out that we intend to continue to comply with the SEC regulation FD. As such, we will not be providing guidance or projections outside of public forums.

You should also be aware that your participation in the Q&A session constitutes your permission to transcribe and rebroadcast any comments you may make.

Before I turn it over to Matt, I wanted to provide a brief explanation for the change in the timing of our call. As most of you are aware, we provide a monthly business update recorded message on the first Thursday following the end of each fiscal month. Given the timing of this month's recorded message in relation to our year-end's earnings release, as well as the nature of the disclosures on current business, we felt it was appropriate to move up our earnings call and provide appropriate context to our current business outlook ahead of this outstanding recorded message.

On advice of counsel, we notified the markets of this change after market close yesterday, allowing for a full business day to elapse prior to this call. We apologize for any inconvenience this change in scheduling may have caused.

As a result of the change in timing, the financial results being discussed today should be considered preliminary. Our auditors are in their final stages of examination but are normally farther along at this time when we hold the call.

Now I will turn it over to Matt McCauley.

Matt McCauley

Thank you, Jeff. Thank you for joining us on our earnings call today. I will start with a brief update on fourth-quarter key financials, discuss new product safety regulations, give an update on the impact of the economy, and then Blair and Kip will provide more details on financials and product. I will then conclude with our strategies for 2009 and beyond.

Overall, we're pleased with our fourth-quarter results. During the quarter, we were down 2% in comp sales and up 4% in total sales, a significant accomplishment in the current retail environment. While we anticipated gross margins to be down in the quarter, they were down more than expected due in part to charges incurred by complying with new product regulations that I will discuss more in detail in just a few minutes.

We also tightened up on expenses during the quarter and leveraged another additional 340 basis points in SG&A on an adjusted basis year-over-year. In the end, due in part to some tax planning offsetting some one-time charges, I'm pleased to report we were able to generate income of $1.00 per share for the fourth quarter, bringing our annual earnings per share to $3.21, up 20% to last year.

Now turning to 2009, our earnings for the first quarter are anticipated to be substantially reduced this year for two major reasons. The first is a temporary impact to sales and margin as a result of some changing regulations in children's products. The second obviously is the challenging economy.

Let me first break out the impact related to regulation changes. Then I will discuss the impact that the economy is having on our business.

As many of you know, there have been a few changes to consumer product safety laws this last year. The first has to do with lead levels in products for children, and the second has to do with a chemical called phthalates, found in plastics and in many screenprints. Let me provide some background on the timing of the new regulations and our response to each issue. I will first touch on the lead issue.

In August, Congress passed a new safety law called the CPSIA that in part limits the amount of lead that can be contained in any component of children's clothing. The new law was set to take effect on February 10, 2009. On September 12, the Consumer Product Safety Commission announced that the lead limits would be enforced retroactively. As such, all products sold after February 10, 2009 would be subject to the new lead limits.

As many of you know, we operate on a nine to 12-month product cycle. In order to comply with the new laws, we launched an aggressive effort to test all styles in our 800 plus stores and remove any styles that did not meet the new limits prior to February 10.

We also attempted to make changes to any product still in the pipeline. Notably, a clarification of the law addressing accessibility of any component containing lead was issued on February 6, four days before the deadline for compliance. This clarification eliminated concerns for the vast majority of our styles that were previously thought to be noncompliant. However, we had already pulled product from the floors and changed production lines in order to be compliant with the regulations as they were initially outlined. While the timing of this clarification was unfortunately late, we took the steps we felt necessary to comply with the law and ensure our products met the highest safety standards.

The second issue has to do with the chemical called phthalates. It is sometimes used in plastics for pliability and often used in screenprints. On November 17, 2008, the CPSC announced that the phthalates requirements would not apply retroactively to inventory. However, an update to this regulation came on February 5, announcing that the law would apply retroactively and that certain products could not be sold after February 10, 2009, regardless of the production date. This change rendered effectively 1.7 million of our product obsolete. This change caused us to pull sleepwear for ages three and under off all of our shelves.

In summary, the regulations themselves did not cause any significant problems on their own. However, our cautious interpretation of the new laws and the timing of the deadlines provided to be compliant impacted the fourth quarter of 2008 and will impact sales and gross margins for the first half of 2009. The impacts of these changes, while significant, are temporary and should only affect the first half of '09.

The impacts to our product assortments are as follows; first, our inventory level is below plan due to the write-off of noncompliant product, which is reducing our sales. Second, because we are all about outfits, the loss of some styles negatively impacts the sale of their matching counterparts. Third, we are experiencing some delivery delays for products that were changed in the pipeline. And lastly, sell-through of reworked product lines has not been as strong as we typically experience due to missing fashion components.

Though it is difficult to accurately quantify the full impact of this issue, we're estimating that roughly half of the decline in Q1 sales is due to missing, late or reworked styles. This is a near-term and temporary impact to sales and margin and does not represent a long-term or fundamental challenge for our business model. We are not guiding the second quarter at this point, but we do anticipate some negative impacts to the second quarter as inventory levels will be under-planned. We expect by the third quarter of 2009 to have this issue fully behind us.

We recognize these charges are significant, but keep in mind that we take safety very seriously. We must err on the side of caution when it comes to safety. We are a kids company with a 33-year reputation of trust with our customers. They know they will get the highest quality product from us. So anytime there are regulations around safety, we go above and beyond to ensure that we are compliant. This commitment can be very costly in the short-term. But we believe that this is what is necessary to build a brand that will be around long after the first and second quarters of 2009.

Now turning to the impact that the economy is having on our business. Like most retailers, we're seeing consumers spend less. However, our number of transactions are stable and growing slightly. And though the increase in transaction count is not enough to completely offset the lower average transaction, we're encouraged by the results of our efforts to acquire new customers.

We're also seeing pressure on the average unit retail as the consumers are looking for more and more values. This is always a balancing act of protecting the brand, full-price selling, managing inventory levels and maximizing gross margins. The approach we have taken and will continue to take is to leverage our existing branded events. We have flexed the length of certain events rather than automatically taking deeper markdowns. This has helped to maximize gross margin dollars, kept inventories in line and at the same time, increased our value proposition to the customer. We started this strategy in the second quarter of 2008, and we will continue it throughout 2009.

Blair will now give a more detailed update on financials, and Kip will lay out product performance and opportunities. Then I will conclude with our 2009 strategies and major areas of focus.

Blair Lambert

Thank you, Matt. As reported in our press release, net sales from retail operations for the 13 weeks ended January 31, 2009 were $284.8 million, a 3% increase over $275.3 million in net sales from retail operations for the 13-week fiscal quarter last year. Other revenue for the quarter attributable to our Play & Music operations was $3.9 million compared to $3.2 million in the prior year. In total, net sales for the quarter were $288.7 million versus $278.4 million for the prior year, an increase of 4%.

As previously reported, comparable store sales for the fourth quarter decreased 2%. During the quarter, we saw an increase in the total number of transactions, a decrease in the average transaction value, units per transaction were slightly up, while average unit retails were down to the prior year.

For the full fiscal year, total net sales increased to just over $1 billion, up 9% versus the prior year. Comparable store sales were flat to the prior year. The total number of stores opened at the end of the quarter was 886, including 584 Gymboree stores in the US, 29 Gymboree stores in Canada, two Gymboree stores in Puerto Rico, 118 Gymboree Outlet stores, 115 Janie and Jack shops, and 38 Crazy 8 stores. During the quarter, we opened a total of 15 new stores and closed two. The total square footage under management at the end of the quarter was 1,735,000 square feet with an average store size at roughly 1960 square feet.

Turning now to gross profit, gross profit rates for the fourth quarter of 2008 decreased roughly 510 basis points to 43% compared to 48.2% for the same quarter the prior year. The reduction was due to a number of items including

one, lower average unit retail prices associated with the economic downturn; two, the selloff of product that would not have complied with new consumer products safety laws that went into effect on February 10, 2009; three, a $6 million write-off arising from the new consumer product safety laws; four, negative occupancy expense leverage; and five, a relatively lower gross margin rate associated with the new Crazy 8 brand. These items were partially offset by lower product costs and buying cost leverage.

I would like to expand a little on the write-off associated with the changes in the consumer products safety law. This $6 million item can be divided into three buckets. First, roughly $3.8 million is related to the CPSIA's limitation on lead content within components of children's clothing that Matt has discussed. Secondly, we have written off an additional $1.7 million worth of product as a result of the new interpretation of the CPSIA law related to phthalates announced by the Consumer Products Safety Commission on February 6, 2009.

Lastly, as of February 10, 2009, we owned a large number of styles with very small unit balances remaining in inventory. Most of these styles had been produced prior to the issuance of the new law in August. While we do not have a large number of units owned in any one style, in total the cost value of the goods was roughly $500,000. Because it was not practical to test these styles, we chose to destroy them rather than risk noncompliance with the new laws.

Let me now turn to SG&A expense. In the fourth quarter, SG&A as a percentage of sales decreased roughly 450 basis points to 27.9% of sales compared to 32.4% in the prior year. Notably SG&A in the prior year included a non-cash catch-up charge of $3.2 million related to performance-based stock grants. Excluding this prior year charge, SG&A for the fourth quarter still fell by 340 basis points versus the prior year. The SG&A expense decreases were driven by lower marketing costs, reduced corporate compensation, leverage of store compensation, and decreased professional fees.

For the quarter, operating income was $43.6 million or 15.1% of sales compared to $43.8 million or 15.7% of sales in the prior year. Income after-tax was $29.5 million or $1.00 per diluted share compared to $0.93 per diluted share in the prior year. Notably, our tax rate for the quarter was 33.2% versus 39.8% in the prior year. The lower tax rate versus the prior year is primarily due to tax planning efforts that resulted in the recognition of domestic tax credits arising from foreign sourced earnings and tax payments. For the full year, net income grew 16% to $93.5 million, while earnings per share grew 20% to $3.21 per share.

Let me now move to the balance sheet. Cash and cash equivalents at the end of the quarter were roughly $140 million with no short or long-term borrowings outstanding. Inventory at the end of the quarter decreased to $115 million from $119.5 million in the prior year. On a per square foot basis, inventories decreased roughly 16% due to the write-off of products that does not comply with the new consumer product safety laws, lower product cost, a change in the timing of product receipts and tighter inventory purchases in some brands. Gross capital expenditures for the quarter were $9.9 million. For the full year, gross capital expenditures were $56.2 million. Depreciation expense for the quarter was roughly $9.1 million. For the full year, depreciation was $34.9 million.

Let me now speak to our plans for fiscal 2009. As noted in our press release, we expect that a challenging retail selling environment will continue throughout fiscal 2009, making it very difficult to anticipate quarterly sales. In light of this uncertainty, we plan to only provide quarterly guidance based on current trends during fiscal 2009.

As has been our practice, we have taken a cautious approach in developing our plans for the first quarter. We're planning for first-quarter earnings to be in the range of $0.18 to $0.25 per diluted share. This first-quarter earnings estimate includes roughly $0.02 per diluted share associated with Crazy 8.

Looking at sales, we're planning for negative comparable store sales in the range of 20% to 25% during the first quarter due to the continuing difficult retail selling environment and the impact of the new product safety regulations on current product assortments.

In terms of real estate, we plan to open 16 new stores during the first quarter, consisting of five new stores for Gymboree, eight new Gymboree Outlets, three new Janie and Jack shops. We also plan to remodel, expand or relocate 20 Gymboree stores. For the full year, we're currently planning to open 75 new stores consisting of 25 Gymboree stores, 20 Gymboree Outlet stores, five Janie and Jack shops, and 25 Crazy 8 stores. Total capital expenditures for the first quarter are planned at $16.5 million. For the full year, we're planning capital expenditures at roughly $50 million. These expenditures will support new store openings, remodels and relocations, along with targeted investments in our distribution center and other information technology systems and infrastructure investments in support of various initiatives.

Depreciation for the first quarter is planned at $9.2 million, while full-year depreciation is planned at roughly $38 million.

In terms of gross margin during the first quarter, we plan for a reduction of about 800 basis points. Roughly half of the decrease is due to deleverage of occupancy costs associated with the negative comp store sales. SG&A is expected to deleverage by approximately 350 basis points. Our tax rate for the quarter and year is expected to be in the range of 39% to 41%.

Now I would like to turn it over to Kip for a discussion of our merchandising activities.

Kip Garcia

Thanks, Blair. At Gymboree, as Matt said, we are pleased with our Q4 results. At the department level and as we experienced all year, our boy departments posted the strongest comps followed by newborn.

Turning to our boy business, a key comp driving class for Q4 was graphic tees, which benefited from our team's focus on developing themes that resonated with our boys and their moms. Artwork color and detail was improved to add more value and create easy outfitting, and age-appropriate humor was injected into our collections, resulting in an emotional connection to the product.

Boy woven shirts also drove comp. This class was a key assortment focus in 2008 as we built our boy casual dressy offerings throughout the fourth quarter. Woven shirts are an essential element to creating dress-up outfits when layered under a great sweater or vest and paired with a great woven pant. Fabrics, patterns, construction and details were all improved in order to create the perfect menswear shirt, and our customers responded positively to this category.

Boy sweaters was also a growth class for the season, and we felt that woven shirts supported this trend. For newborn, our brand new baby soft knit collection continued to drive sales within this department. Our whimsical baby monkey concept was perfect for fourth-quarter gift giving and unique to Gymboree.

Our girl department comps were tougher, partly because girl lines were against our strongest performing Q4 lines from last year. Having said that, we did have lines that performed strongly within the quarter. For instance, we are pleased with our polka dot gift line, which set the first week of November. Our customers love the oversized dot pattern in their favorite pink and brown colors, and mix and match outfitting was made easy by the simple, easy to understand color palette.

We were also pleased with the performance of our spring trends daisy line that launched just before Christmas. Once again, outfitting was easy, and our happy, bold, pop daisy prints and artwork created a fashion option for last-minute gift giving.

Looking to our current business, our customers have cut back due to the economic downturn, and our sales have been further negatively impacted by the new regulations on lead and phthalates. Kid girl has been the most impacted by the new safety regulations, which has resulted in discontinued, canceled, or late styles that impact our ability to provide the maximum amount of mix and match options for our customers who are having trouble creating outfits when key top or bottom styles are missing from the new collections.

And our customers are also telling us that they missed our iconic sparkle and shine due to the removal of trims and bling from many styles in our current lines. We are fortunate that our business model delivers a new line every two to four weeks, and as a result, we will quickly bring our collections back to the level of trim and detail that our customer loves from us. With every new delivery, there is an improvement in our offering of head to toe mix and match styles, level of detail and the amount of trim and bling that our customers come to us for. We are planning that our lines that arrive starting in May will be back to normal, and our product offering going forward is better than ever.

Looking to the balance of 2009, we have focused our strategy across three overarching areas. We believe that we still have marketshare opportunities in boy and newborn, and we have opportunity to improve our girl department performance. Our teams have developed detailed plans to support these strategies, and I'm confident that we have positioned our product to maximize our share of customer spin for children's apparel in '09, and following are the actions that we have taken to do so.

Starting with our girl department, our mission for 2009 is to guarantee cute, easy to mix and match head to toe outfits, offer age-appropriate classic styling, offer emotional themes, artwork and prints that are iconic to Gymboree, and keep our concepts and styling fresh and new to give our most dedicated Gymboree customers a compelling reason to buy. For boys, we will guarantee age-appropriate classic styling that maximizes boy outfitting since our Gymboree mom shops for outfits for their boys as well. Offer fresh, aspirational boy themes, graphics, and icons; offer authentic boy details, washes, styling and fabrics; and consistently offering boy wardrobing options from active playwear to schooltime to casual dress-up.

And for newborn, we have also identified sales driving strategies for 2009. Our mission is to ensure that we are the destination for shower and newborn gifts, and our strategies include, ensure that we offer our customers fashion collections that are easy to outfit from head to toe for both newborn boys and newborn girls; ensure that our concepts, styling and artwork make an emotional connection with our customer, especially for the size range; consistently offer lines that are fresh and new for our most dedicated Gymboree customers, and for our youngest ones, offer supersoft mix and match essentials every day that can be easily built from the simplest gift to the largest from all of us, shower gift.

Turning to Janie and Jack for Q4, customers in this channel are cutting back, and our regular price business was challenging throughout the quarter. A key learning from Q4 was that our strongest reg lines had broader color palettes than what was historically performed in the brand. We are pleased with our winter line, which featured bright pink and green penguins for girls and bright green panda concept for boys, both of which are good indicators for our future lines, which will offer brighter and tighter color palettes.

Looking forward to 2009, we are excited about our collections, color palettes and concepts based upon our learnings from 2008. We are offering brighter and tighter color assortments and more clear-cut outfitting to make it easier for our customers to build perfect wardrobes or gifts. We have also added more emotional icons to our collections going forward, which has been a key selling factor in our most recent lines.

In layette we raised the bar on the level of handwork and detail that we included in our Signature collections, and it has paid off. In 2009, we will differentiate this important segment of our brand by continuing to refresh our Signature collection with details, new colors and icons, plus elevate our gifting offering with the addition of gift topper plush, books and bath apparel accessories that are emotional hits at the baby shower.

And finally, even during these tough economic times, our special occasion dress-up collections have continued to perform well, and we will continue to expand the strategy in 2009. We have found that Janie and Jack is actually a bargain for wedding party or special occasion apparel for kids when compared to upscale bridal specialty shops, and we have also been very pleased to find that this category is completely incremental and does not cannibalize our regular fashion assortments. As a result, we will be expanding the store base of this product to reach even more customers in 2009.

Turning to Gymboree Outlet, we were pleased with our Q4 performance, which was helped by repeating the best ever Gymboree line concepts from 2007. Key successes for Q4 also included our Jingle Deals, which offered strong gift categories at bargaining prices, and our Black Friday promotion, which was maximized by Midnight Madness events in most of our malls.

Looking to 2009, we have been pleased with our initial sales of our current Easter collection and plan to further strengthen our future performance with the following strategies, which include, improve our seasonality through adjusting our line flows and rightsizing them to key outlet specific timing, increase our value message with sharp pricing on key categories everyday and offer compelling price points on special promotions. And based upon the success of Brand New Baby in Gymboree, we will be launching the knit-driven brand new collection for outlet in the second half of the year, which will include the bestsellers from past Gymboree lines, plus key sellers from the outlet.

Turning to Crazy 8, we continue to refine and adjust our assortments as we learn more with each line. As we have said in previous calls, we have made changes to our product going forward that will drive sales and increase our marketshare. We are very pleased with the positive response to our spring trends kid girl collection which landed in December because it reflected the styling direction that we are taking going forward.

Looking to 2009 for Crazy 8, we have launched the following strategies. We will be all about offering our customer outfits with All-American classic styling and details at value prices. We adjusted our flows and line size across all departments in order to maximize seasonality and have the right product when our customer wants it. We will consistently offer newborn fashion outfit collections and launch newborn essentials in the second half of the year. We will consistently offer boy and girl must-have categories as boy active pants, polos and collared shirts and girl fashion tees and leggings, as well as core denim for both boys and girls. We will expand girl accessories to head to toe dressing and expand boy furnishings to include more underwear. And we have adjusted our floor layout in the stores to assist easy shopping, highlight outfitting, as well as create homes for our key categories.

We feel that our product improves with each delivery going forward and will be the most improved starting with our back to school collections in August.

And now I would like to turn it over to Matt.

Matthew McCauley

Thanks, Kip. 2009 is clearly an unusual year for us brought on by a challenging economy and regulatory changes, and clearly we are not happy with our projected Q1 performance. But 2009 is also a year of opportunity for Gymboree. This is arguably one of the best times to invest and build for the future. Leases are low, construction costs are down, and factories are hungry for solid financial partners, making cost of goods reductions possible.

With that in mind, our strategy for 2009 and beyond can be summarized into three major areas – an aggressive offense targeting customer acquisition and loyalty, an expanding defense with new expense reductions, and an increased focus on cash reserves for strategic opportunities. With the consumer spending less in this economy, our offense will focus on acquiring more customers, so we're investing in marketing. We need to take better care of our existing customers, so we are investing in loyalty. We need to acknowledge the current challenges but not lose sight of the future, so we're continuing to invest in great real estate deals, Crazy 8 and appropriate remodels.

Because we see 2009 as a window of opportunity that can help shape our future growth, we are expanding our defensive strategies to aggressively reduce expenses. This will help fund projects that will have a lasting positive impact on our business. We have reduced all corporate and senior field salaries, eliminated the senior executive bonuses, tightened headcount, suspended the 401(k) plans, suspended the ESPP plans and pushed some non-essential remodels just to name a few. We are also in the process of consolidating our US and Canadian distribution centers, continuing our store payroll efficiencies and continuing our focus on cost of goods reductions.

As for increasing our cash reserves, we have over $140 million in cash and plan to add to that this year. We have very high initial margins, enabling us to put cash on the balance sheet even with downturns in sales. We have also reduced some non-essential expenses that will contribute to our cash reserves. Again, this focus on cash will allow us to take advantage of possible opportunities in this new economy, as well as be prepared for furthering economic decline.

Before I close, I want to give a little more detail on Crazy 8. We're seeing improvements in both sales and margins. The downward pressure in the economy, combined with a slightly smaller footprint, is creating opportunities for better leases. The initial margins are growing with increased purchase orders, and the efficiencies developed in Gymboree payroll will be implemented in Crazy 8 this year. As difficult as it is to start a new concept, especially in a down economy, we are very encouraged by the fact that we should be able to achieve positive four-wall contributions with existing sales, but with larger initial margins that are increasing naturally as the business grows, and we're planning to open 25 new Crazy 8 stores this year.

Now in summary, 2009 is a time of opportunity. While we're reducing expenses and improving efficiencies across the Company, we're also investing for the future. We plan to take advantage of this economy and build new stores, grow our newest concepts, expand Play & Music internationally, acquire new customers, increase loyalty with existing customers, and forge new relationships with factories. We are in a solid financial position, and we can afford to focus on the most important things right now like the customer and future growth. By taking advantage of the right opportunities, we will come out of this time having captured more marketshare, gained more customer loyalty and increased our brand awareness, setting Gymboree up for even stronger long-term financial growth.

Now we are happy to answer any questions that you may have.

Question-and-Answer Session

Operator

(Operator instructions). Betty Chen, Wedbush Morgan.

Betty Chen – Wedbush Morgan

I was wondering if you can start off by maybe giving us a little bit more clarification; I and really appreciate all the details regarding the regulatory changes and how that is really impacting not only Q4 but certainly the first half. But in regard to the Q1 timeframe, it would be really helpful if you can maybe try to quantify like you did for the fourth quarter, where I think you detailed that roughly $6 million of write-off did hurt the gross margin in Q4, and if we can get some kind of guideline around that for the first quarter, that would be helpful. And then to clarify, did you mention that you also expected maybe half of the sales impacting Q1 was also due to the regulatory changes?

Matthew McCauley

Yes, that is right. So it was very easy for us to quantify the fourth quarter because those were simply write-offs of inventory. The first quarter is a little bit more challenging because it is an impact to sales. So I just want to kind of outline why it is so impactful to our sales. So if you look at the first, as I mentioned, that because we are all about outfits, when we have styles that drop out, the remaining styles that are matching counterparts get negatively impacted as well. Because we are all about the details, Gymboree is all about the details, many of those details were previously thought to need to come off until we had alternatives. And so a lot of those came off for lines in the first part of Q1, and that is impacting the remaining product in the stores as well.

Because a lot of those are on the girl’s product and the girl’s is the largest percentage of our sales, it is also negatively impacting us. And then in addition to – as we already mentioned, just simply the fact that we don't have the inventory of those items that we pulled. And so the reason that we're saying it is roughly half, we wish that we could give very detailed outline of exactly how much it is impacting. But because so many of these things kind of have a halo effect, it is very difficult to clarify how much of the economy is impacting the sales and how much is due to the regulatory changes. So that is why we said roughly half. But I think if we had more clarity on that, then we would feel comfortable guiding the whole year.

Betty Chen – Wedbush Morgan

And then so is there any way you can give us a sense of what percent of the spring inventory buys were affected by the changes or maybe the percent of styles so that we could kind of get a sense of beyond obviously the EPS impact is really how large of a magnitude this is?

Matthew McCauley

Sure. As you look at the first deliveries in the first part of Q1, it impacted to some degree in the girl business, up to half of the lines in some cases, because if they were not affected directly they delivered late. And so we have got late styles on top of styles that have been negatively impacted by the changes. And so I would say that on the girl’s side, roughly half of the line for the first few deliveries in the first quarter impacted to some degree.

Betty Chen – Wedbush Morgan

And I think you mentioned that this is going to continue to impact the second quarter as well. Is it to the same magnitude or sort of in a lessened –?

Matthew McCauley

It will not be to the same magnitude, but it will impact the second quarter. And as we get closer to guiding the second quarter, we will break out – and actually we will have a better read as well, we will be able to break out a little bit more of the impact. But it is to a lesser degree.

Betty Chen – Wedbush Morgan

That is very helpful. And then I guess if I could also in terms of some of the strategies for this year, you talked about expense reductions, and certainly it looks like in Q4 we were already starting to see some of that benefit. Is there any way you can help us understand what were the biggest drivers of cost savings in the fourth quarter or which components will be the most beneficial in 2009?

Matthew McCauley

Sure. If you look at 2009, a lot of it is coming from payroll reductions, pushing out some capital expense in terms of cash. If you look at the fourth quarter, marketing expenses was down. Compensation was down. Both salary as well as incentive compensation, and store compensation, we were able to leverage; that was down as well. Professional fees we reduced, and stock-based compensation as a comparison was down as well. But the biggest drivers were between marketing and compensation and store compensation. Those were the biggest drivers in the fourth quarter and will continue to be through 2009.

Betty Chen – Wedbush Morgan

Lastly, I know you had talked before about product cost savings in 2009. Given some of the changes happening, is it fair to think that we're not going to be able to see some of those savings in the first half, or how should we think about that for the –?

Matthew McCauley

You will still see the savings and the product cost savings actually through 2009. We have already placed and negotiated prices through 2009. We're in the process now of working on 2010. And, as I mentioned in the call, because factories are also looking for financially sound partners, we're finding that it is actually helping our strategies of reducing cost as we partner with factories that are looking for people that can pay the bills. And so that will continue through the rest of the year this year because that is already done, and so far we're seeing encouraging outlook for 2010.

Betty Chen – Wedbush Morgan

Is it comparable to the past, Matt, where I think you have alluded to maybe 100 basis points?

Matthew McCauley

That is right.

Betty Chen – Wedbush Morgan

In the past? Okay. So it is comparable to those levels?

Matthew McCauley

That is right.

Betty Chen – Wedbush Morgan

Great. And sorry, just one last housekeeping. What was the Crazy 8 impacted in the fourth quarter?

Matthew McCauley

The fourth quarter I don't think we broke that out, but it is right around $0.06, and as we mentioned, that is lessening in 2009.

Operator

Brian Tunick, JPMorgan.

Brian Tunick – JPMorgan

After all your great years the last couple of years, there is going to be a lot of attacks on your credibility probably tonight, tomorrow and when you knew, etc. So maybe, Matt, can you talk about maybe more the timing here and what were your options for communicating this to the marketplace? And also, do you think we should expect others, either children's specialty retailers or even department stores or the discounters, to have the same inventory disruptions?

Matthew McCauley

Okay. So your first question is about credibility and the timing. Let me just address the timing. First of all, we had always communicated when asked about the impact of the fourth quarter, it was always in our number. We've communicated that it was. In terms of the impact to the future for Q1, it was a process of discovery for us like it will be and has been for other retailers. When we heard about it, we heard about it when everybody heard about it. And once you hear about the regulation, there is a process of going through and finding where you have issues. We have over 25,000 styles in over 800 stores that we needed to assess, and that takes time. You don't know the impact until you have actually assessed them.

And so as we went through the process of discovering, as you do that, you realize that you need to discover more. And so that process was going on through the third and fourth quarters. And until you actually get to the point where you are seeing sales, it is very hard to quantify what that impact is. We were very comfortable quantifying what it was for the fourth quarter, and it was always in the number. And till we got to the first quarter, two things happened.

Number one, we started to get a read on the sales. We started to see the impact of the lost inventory, the impact of the changed product, and that was the first we started to assess how big the problem was. And second, we had a change in the regulation that did not give any time for anyone as it relates to the phthalates on sleepwear. So there was no time for us to communicate or react that it was a change in regulation.

So those two things had to happen for us to really get our arms around how big it was, and that is why we moved the call up. As soon as we understood it, that is why we communicated it. Would we like to be more proactive? Absolutely. Would we have like to have been further ahead of this? Absolutely. So we are as frustrated with ourselves and the regulation and lack of clarity as you are. So hopefully that answers that communication as soon as we understood it.

The second question is around whether or not you should expect it from other retailers. You're going to have to ask them, but I can help you understand why it is so significant to us. It is a much bigger impact to our business then perhaps it will be to others, mainly because of the outfit nature of our business. Secondly, because we are about all of those details. Girl is such a large percentage of our business, and we took a very cautious interpretation of the law, which the fact that we went on a proactive search to look for all of those styles in our stores so that we could test them and say that they met the new regulations, the more you look, the more you are going to find. And we were very aggressive on that front, and the cautious nature I say because anything that we could not test, we eliminated rather than taking the risk of having something not be in compliance.

So hopefully that answers your question. But certainly as soon as we had the information, we are sharing it as soon as we got our arms around it.

Brian Tunick – JPMorgan

And just any color on the inventories? Obviously they are down a lot because of the pooled inventory. But on a pro forma basis, can you talk about your comfort with the inventory levels?

Matthew McCauley

Yes, we are lighter on inventory than where we want to be. That is impacting our sales. But there's four major reasons that our inventories are down.

First, we had planned to be down slightly. We had anticipated that sales would be tougher in '09, and we had planned to be down slightly, obviously the inventory that we had to eliminate because of the product issues, quality issues, and the product CPSC, obsolete product that we had to reduce, as well as the fact that we have had some delivery delays. And on top of that, we have had items that we could not test that we had to eliminate. And then our average unit cost is down, which is also making the number look lower than the units really are.

Brian Tunick – JPMorgan

And just the final question, you highlighted the cash balance and talked about potentially strategic something initiative there. Can you maybe just talk a little bit more about that, and would you change your view obviously with what the stock is indicating after-hours?

Matthew McCauley

Yes, with cash we have always said we will be opportunistic with it. Obviously the economy creates opportunities and provides opportunities strategically, and we have always said we would be open to those if anything made sense. At the same time, you have seen us do stock buybacks in the past, and that is always a conversation with the board. And it is going to be balancing what is the best use of our cash at this stage at the same time being prepared in case the economy continues to deteriorate.

So those are the things we are always weighing. No matter what cash is king, and we want to have as much as we can right now.

Operator

Rick Patel, Bank of America/Merrill Lynch.

Rick Patel – Bank of America/Merrill Lynch

You mentioned that you have a nine to 12 month lead-time for your product. Can you elaborate on how this inventory issue will not continue for most of 2009? I'm just trying to understand how things can get better by the third quarter.

Matthew McCauley

Yes, because you can actually make an impact. We can catch things in the product lifecycle. When we're talking nine to 12 months, we're including design time, development time. We are in the process of creating samples and going back and forth with the factories. So when you start to make changes, we are able to impact the lines. As Kip mentioned, we are still able to impact before they leave the production line as we start to get into May.

Rick Patel – Bank of America/Merrill Lynch

All right. And then on the SG&A line, can you just provide some more color on the SG&A dollar growth that we can expect for 2009? Should we expect the same level of decline that we saw in the fourth quarter?

Matthew McCauley

We have not really guided 2009 yet on the full year. And so I think it would be just a little premature for us to give guidance on that for the year.

Blair Lambert

For the quarter though, we did mention to expect some negative SG&A leverage of about 350 basis points. That is going to be driven by – really due to the negative comp, and it's going to show up in things like store compensation, marketing, depreciation offset by some benefits, favorable leverage and corporate compensation.

Operator

John Zolidis, Buckingham Research.

John Zolidis – Buckingham Research

The comp in the fourth quarter was down 2%, and you are saying down 20 to 25% in the first quarter with roughly half the impact due to all of these noisy events. But when I'm looking at your history, there hasn’t been a lot of times where comps went from down 2 to down 12 overnight. So with all due respect, I mean could it – the impact of the products that you're taking out of the stores, etc. be much, much greater than just half of what is going on?

Matthew McCauley

Absolutely. It very well could be, and that is what we said. It is very hard for us to separate how much of it is the product impact and how much of it is the economy, and that is exactly why we are not guiding the year. Of course, we all have our opinions about what we think it is and try to quantify that halo effect. But we're looking at the same thing going, how do you go from down 2 to trending down 20 to down 25?

But at this stage that is what we're comfortable with in terms of outlining it. It is going to be – that is why we're not guiding the year. Until we get a better comfort level of what our baseline is, it is very hard to separate how much of this is the product impact new to regulatory issues. So yes, you are asking the same question that we are looking at, but at this stage it is very, very hard to separate that out.

John Zolidis – Buckingham Research

Okay. I mean that is understandable. Look, guys, the fourth quarter, very strong results certainly given the environment, and you guys have a great long-term track record of delivering. And it looks like you got a little bit caught by these regulations.

Matthew McCauley

That is right.

John Zolidis – Buckingham Research

And it does not really change, I guess, the potential for your Company over the long-term. So in any case, I will be glad that when this is over and we can look forward to results coming back to what we know to expect from you guys.

Matthew McCauley

Thank you. We feel the same.

Operator

Tom Filandro, SIG.

Tom Filandro – SIG

You know, Matt, just to expand a little bit on that question John just asked, have you guys thus far witnessed a dramatic change in either the transactions, the AUR or the UPTs? Because it sounds like what you're saying is the outfit per piece has been impacted. So I would imagine that would have been a negative impact on UPTs. And obviously we all know what the environment is like out there. It is clearly challenging. You guys have alluded to AUR pressure for quite some time, made it very clear. But transactions have kind of held up. So can you kind of help us understand why the differential from sort of a 2% to an 11% drop?

Matthew McCauley

That is right. Well, we are actually seeing a decline in the average trend and the number of transactions in February as we have seen this – the impacts of the regulatory issues and the missing product there and the changed product. So those things all contributed. At the same time, the margins are down as well. So when we've got all of these things kind of compounded in the first month, that is what is driving that comp so far down and the margins down. And so the remaining product that no longer has a matching counterpart, well, now you're going to have pressure on the AUR to make sure you move through it.

So it's a combination of all of those things at the same time that you have already got pressure from the economy. And so the big shift that you are seeing in the fourth quarter we were able to see a number of transactions stay steady and actually increase. Well, you don't have that in the first part of the quarter, and we believe a lot of that is driven by the things that we have already stated.

Tom Filandro – SIG

Okay. And the key comment that you made there, too, was that you're not going to stick around with this product. You have got to move it, so you will be promotional as promotional as you need to be. And so you also are viewing the AURs will continue to be lower?

Matthew McCauley

That is right. We're going to have pressure on AURs. They would have been under pressure anyway, but you've got extra pressure now because of those remaining styles. And we just have to get through these first two quarters and get this behind us.

Tom Filandro – SIG

Understood. Two other quick ones, I think one is quick. You know Kip alluded to that trim and detail comment; the trim and detail comment, is that directly related to the safety issue, or was there something else driving the pullback from the trim and detail on product?

Matthew McCauley

No, that is exactly what – it is directly related to this. There were items that were in question, did not get a lot of clarification in the regulations around certain trim details. And so rather than roll the dice, we pulled them from the product until we could get clarification. And after that clarification came, it actually opens up the window for us to add a lot of those things back. At the same time, we found replacement items that we can actually add back to the products. So you are going to see that happening really through the second quarter and then fully by the time we get to the third quarter.

Tom Filandro – SIG

And just on that topic, Matt, Kip alluded to the fact that customers were – that was where they felt there was a shortfall in the product. Is that more anecdotal or how you guys look at the business, or how did you come up with that conclusion?

Matthew McCauley

We have Gymboree Listens, and we have the ability to hear our customers and categorize all of the types of requests and comments. And we definitely heard from them that they saw the difference in the product and they wanted it back. And so we are very confident that what the customer is saying we heard and consistent with what we were seeing.

Tom Filandro – SIG

And one final one. As it relates to these safety issues, looking past them, I think you did comment that you still thought there was more opportunity to drive lower cost. Can you give us what is that related to? Do these safety issues create – obviously I would imagine that some of them are creating higher costs for you. So help me understand how you get lower cost go forward?

Matthew McCauley

Sure. You have got two things working at odds with each other. One is, with increased regulation, you have increased testing costs and requirements before they leave on their way to the US. So that is pressure on the upward cost.

But what we're finding is two things to help us offset that and actually reduce cost. Number one, factories – although a lot of factories are experiencing challenging financial times, they are also hungry to find partners that they have confidence can pay their bills. A lot of factories are kind of getting stuck in trouble because companies are going under and cannot pay. So fortunately we have got a great relationship and reputation with factories, and they are hungry to do business with us. So that always helps on the negotiations.

And secondly, we're still exploring new countries that other companies have been in for quite some time that are relatively new to us, like Africa. India is still expanding. So those offer new opportunities for us as our business grows to get into factories that have lower cost of labor.

Does that answer your question?

Tom Filandro – SIG

It does. Thank you very much.

Operator

Adrienne Tennant, FBR.

Adrienne Tennant – FBR

So my question is, how does these – what prompts these regulatory bodies to suddenly come up with new regulation? Is this the final chapter do you think? And what types of lead-times going forward, if there were to be something else like this, do they give you?

Matthew McCauley

That is a good question. It all started – seems to have started in 2007 with toys. These latest ones on phthalates and lead kind of moved into the children's market with bottles and sippy cups and kind of rapidly moved their way into children's apparel.

I wish I could answer the question on lead-times. I think if history is our guide, their top priority as is with us is safety. And so once they identify something that could be potentially a risk then, I don't think they are as concerned with lead-times. It makes it more difficult for us. It is challenging and expensive for us, but at the same time, we have to move as quickly as we hear. And our goal is always to be at or exceeding the new regulations and standards.

We do have one coming down the line in August that is actually tightening up what came out on the lead requirements. The lead levels that came out in August of 2008, it is actually being reduced again in August of 2009. And fortunately we have had more lead-time on this and feel confident we will be much more prepared for this one than we were for the last one.

Adrienne Tennant – FBR

Okay. But as far as other kind of categories that you can think of where you would have exposure I mean at least right now, there is probably nothing on the horizon?

Matthew McCauley

Well, there does not seem to be anything on the horizon right now, but you know –

Adrienne Tennant – FBR

Right.

Matthew McCauley

If history is our guide, that does not guarantee. But we feel pretty – what we have done is take a very cautious view and tried to go above and beyond so that we are much more prepared for the future.

The only other piece, something that has been discussed, is formaldehyde, and that is something that is kind of in discussions, but very difficult. There is no measuring levels for it. Formaldehyde is found in a lot of places at very low levels. And so there are conversations about that. That has happened in other countries. So our strategy is to get way ahead of the US and lead the way and make sure regardless of whether or not the US has regulations on this, we want to get ahead of it so that we are not caught.

Adrienne Tennant – FBR

Okay. And with your guidance, the negative 20 to 25, so you said before that is your current run-rate. Easter is later, but I know that in the children's market, your Easter season actually precedes that by quite a few weeks. So is the reason that we should not see any improvement from current levels because this February/March time period really is kind of your Easter season?

Matthew McCauley

Well, that is right. And so much of the quarter – already the impact of February has impacted it. So we have not guided beyond the first quarter. And based on what we have seen in February and taking into account the Easter and the Easter shift, that is why we are comfortable with the guidance we have given on the call.

Adrienne Tennant – FBR

Okay. And then on the marketing side, you said that you would reinvest into prospecting and acquiring customers. Is that – and so should we expect marketing dollars to be up? And if so, is that going to be for the back half when you feel the product is right, or are you even engaging in those prospecting – that prospecting right now in the first half when you still have some of these issues with the product?

Matthew McCauley

We're still engaging in it right now. The dollars won't go up. What we are actually doing is we're reaching more customers with the same dollars. We have got a lot of creative new approaches to our marketing that are leveraging some of the things we have done in the past that we have seen success with. You will see print going up, new partnerships that we have made that will allow us to reach more customers with much better returns with the same or less money.

Adrienne Tennant – FBR

Okay. And then my final question is on the store opening pattern. It is probably one of the more aggressive store opening patterns that we have seen across this space. Are you just trying to take advantage of the deals that are out there?

Matthew McCauley

That is exactly right, and our approach is really evaluating the deals on current sales trends. We are not looking to open stores that we hope will be profitable in the future. We are evaluating every deal based on current sales trends, and if the leases make sense, then we're locking them in and going for it. If they don't, we're walking away. We have also gone back on leases that were not completely baked over the last few months, renegotiated, lowered those lease rates with new sales trends. And we feel like this is actually an ideal time to be opening stores with brands that we're confident in and comfortable with the financials on each by a deal by deal basis. So we are being very opportunistic there, and it could be more than that, it could be less than that. It all depends on the deal.

Adrienne Tennant – FBR

Okay. Thank you very much and best of luck.

Operator

Margaret Whitfield, Sterne, Agee Capital.

Margaret Whitfield – Sterne, Agee Capital

I guess I covered that some toy companies and some other children's apparel companies and to my knowledge these other publicly traded companies have not had this issue. Did perhaps we not put enough resources into the QC department, and if so, are you going to be strengthening your testing capabilities that you can get ahead of these regulations?

Matthew McCauley

Absolutely. We have made some changes in that department and still looking for ways that we can be even more proactive in the future and get ahead of it. So I cannot speak to why the other companies you are covering don't have these issues. But we feel confident that we have gone above and beyond and done the cautious thing to ensure that we have all of our product meeting the new regulations. That is very, very important to us.

Margaret Whitfield – Sterne, Agee Capital

Would you say that February was probably the worst month in terms of impact from the regulations, or would it be consistent throughout the first quarter?

Matthew McCauley

February is definitely the worst month followed by March and getting better in April and into Q2.

Margaret Whitfield – Sterne, Agee Capital

And do you have any way of measuring traffic? Are you still getting a similar amount of traffic as you did in Q4?

Matthew McCauley

We focused more on the number of transactions. Traffic – we do have traffic counters in a sampling of our stores. We do not have a lot of confidence in those to be honest. But we focus more on the number of transactions.

Margaret Whitfield – Sterne, Agee Capital

And was this effect mainly in Gymboree core, or did it also ripple through the other concepts?

Matthew McCauley

It rippled through all concepts, but the major impact was in Gymboree.

Margaret Whitfield – Sterne, Agee Capital

And you mentioned you are short on inventory. Where do you think you will end Q1 regarding inventory per square foot?

Matthew McCauley

We're thinking in the down mid-to-high single digits.

Margaret Whitfield – Sterne, Agee Capital

And with all the payroll changes at the field level, have you experienced a higher than normal level of turnover?

Matthew McCauley

Actually our turn is going down.

Margaret Whitfield – Sterne, Agee Capital

Okay. That makes sense with this economy.

Matthew McCauley

That is right.

Margaret Whitfield – Sterne, Agee Capital

Okay. All the best to you.

Operator

Linda Tsai, MKM Partners.

Linda Tsai – MKM Partners

Would you consider publicizing that your phthalates and lead-free is a form of marketing to show consumers that you are compliant?

Matthew McCauley

You know, we have talked about that quite a bit. I think our approach has always been that we've got a long track record of safety and quality, and that is part of our message, an ongoing message. And I don't know that we would call out those specific chemicals or substances. But it is part of who we are that we want to continually communicate to everybody that we will always put safety and quality first.

Linda Tsai – MKM Partners

And then during the quarter, I mean when some of your customers might have noticed that the sleepwear was gone, did they ask why and did they ask questions? Were they kind of aware of these regulations occurring?

Matthew McCauley

Lots of customers asked why. Some were aware of the regulations. Most ones we explained what was going on. It completely made sense. Interestingly enough, most of them were more passionate about just wanting to get the product, and there is a lot of confidence that whatever we sell is safe and the highest quality. And so I think that a very small amount of consumers know about the regulations. But we certainly have a lot of customers asking questions about why.

Linda Tsai – MKM Partners

Great. And then were there any categories that were not impacted at all, and then how did categories kind of perform relative to your expectations?

Matthew McCauley

There were a lot of categories that were not impacted. But when you are testing for lead, you have to test everything. And so it can be pretty broad reaching. I mean you looking at snaps and buttons and zippers and grommets. So it can touch just about everything in your store, and that is why we did such an aggressive effort to test everything that we felt needed to be and assess absolutely everything that we were selling. That is part of what took the time. But we felt it was necessary to be able to say at the end of the day, we have assessed and/or tested everything that we're selling.

Linda Tsai – MKM Partners

But in terms of what gets tested, do you bring that to a facility that other retailers go to, or do you have your own capabilities to do that?

Matthew McCauley

Third-party as well as our own capabilities. So we did a combination of both when this came out, because there was so much that needed to be assessed and tested. And, as you can imagine, the third parties were overwhelmed as well because everybody was trying to test things that had never been tested before. So it increased the workload of the third parties.

Linda Tsai – MKM Partners

Right. And then just one final question. Do you anticipate having to increase transportation costs at all in the first half, perhaps pulling some product in in light of the product shortages, or are you going to just try to –?

Matthew McCauley

That cost is already included in the number, but yes, there are some transportation charges of shipping product back to our warehouse where we need to dispose of it.

Linda Tsai – MKM Partners

Thank you and good luck.

Operator

Stacy Pak, SP Research.

Stacy Pak – SP Research

A few questions. I guess, first of all, I just wanted to get an understanding of why Gymboree did not have a better sense on the direction these laws and regulations were headed and how you as an organization stay abreast of these kinds of changes and what changes you may have made within the Company to respond to this kind of thing going forward?

And also within that, if you could just kind of address, I mean phthalates and lead, obviously you don't want them anywhere near your kids. How close on the border do you tend to make your products? I would think that you would want to stay very far away from – you have mentioned formaldehyde, anything even remotely like that. And then how if you are paying more attention to this, does this not lead to higher product cost, regardless of going to lower-cost countries?

Matthew McCauley

A couple of things. To answer your first question about how we stay abreast of these things and what changes have we made. Obviously we have a QC department that relies quite heavily on third-parties as well that are very in-tune with what is happening. I think there was a lot of questions about whether or not some of these laws would go into effect, and if they did go into effect, would they be retroactive? I think that was probably the biggest surprise to most people, that they were retroactive. So we stay abreast of it with the QC department, as well as legal and third parties.

To answer your question about changes, yes, we feel like there is an opportunity to be more proactive there, and we have made changes in that department. And in terms of how close do we stay to the line, we always try to be at or above the standards, and I want to clarify a couple of things.

One is around the lead and accessibility. There are many things that contain lead but are not accessible. That is what was clarified in terms of safety. There are items that may have lead inside the substrate or inside the item but are completely inaccessible to the child or to anyone. And those were – that was ruled safe. That clarification came out late.

So to answer your question, how close do we stay to the line? As far away from that line as possible. We did not wait for the ruling on whether or not it was accessible or not. We removed everything and until there was a ruling and then we understand what it is and our standards are at or exceed those that are put out by the government or the CPSC. So hopefully that answers your question on how close we stay to it.

In terms of the cost, the increase in our cost, there is always pressure on cost, mostly around the testing requirements, not necessarily the items themselves. There's always going to be competitive alternatives for things that may be too high in lead content or phthalates. So there's always alternatives and competitive alternatives. The challenge is really in the testing requirements, and there is also always competition for third parties. And so that is – we have seen an uptick in costs there. We are offsetting it through sourcing right now.

Stacy Pak – SP Research

Okay. And on the February – two more, just two follow-ups. On the February comp, could you please give us – somebody else asked for it, I think Tom Filandro, but the UPT, the transactions and the AUR in February, so we can really understand what is happening to the comp ourselves.

And then just on the SG&A dollars, are those Q4 cuts that you made – I know you don't want to give the dollar amount – but the changes you made in Q4 to arrive at the 11% decline, are those cuts sustainable into '09, or were those sort of onetime things?

Matthew McCauley

No, a lot of those cuts were the beginning of some larger expense reductions. As you know, we have been working on expense reductions for the last four years. But those are sustainable. The biggest ones are things that impact the entire year. So yes, to answer your question, they are sustainable.

The question about UPTs, the average unit retail and number of transactions. So the think to note is yes, those are all down in February as we mentioned primarily impacted by – or we feel a good portion of it being impacted by these – the regulation changes. Notably if you kind of go across the brands, the biggest declines are really in Gymboree, which was most impacted. And we are seeing less of a decline in our outlet business and actually improvements in our Crazy 8 business.

Stacy Pak – SP Research

I guess, is the decline in February UPT which is what drives you back to the outfitting issue, or is it equally across those items, UPT transactions, AURs? Because when you made a point earlier saying this is more about us because the outfitting because you don't have all the other items?

Matthew McCauley

Well, it is more about us because of the outfitting, as well as the details that are removed, as well as the lines that – the items that are delivering late. And so we have pressure on all of the KPIs, but the biggest pressure is on the Gymboree side. And that is where we are seeing the largest decreases, and we are seeing it across all of the KPIs, to a lesser degree in the outlet and actually seeing improvements in Crazy 8. And we have the same type of pressures in Janie and Jack both with the economy, as well as some of the regulation impacts.

Operator

Marni Shapiro, The Retail Tracker.

Marni Shapiro – The Retail Tracker

Sort of the Armageddon for you, I guess.

Matthew McCauley

We have had more enjoyable calls.

Marni Shapiro – The Retail Tracker

I'm sorry. I'm going to ask one quick follow-up and then I have a housekeeping question for you. Is the fallout from Q1 – it's primarily in Q1 and Q2. And let's – getting away from the rhinestones and the glitter, let's talk about the outfitting.

I guess as you round into back to school, if your customer has been turned off by what you saw over spring and summer, she could not outfit, maybe she went somewhere else to do that. Are you forward thinking about how you're going to win her back into the store for back to school because that is going to be an important turning point for you guys as this new product comes into the stores?

I'm just curious, I know it is a bigger deal at Gymboree, but between Janie and Jack and Crazy 8, which of those two is the bigger impact?

Matthew McCauley

The bigger impact, Janie and Jack, we will answer those ones first. Less of an impact to Crazy 8. And obviously it's a smaller store base for us, so a smaller impact to the Company. Absolutely we're always looking at ways to capture that customer's loyalty. We have a very, very loyal and passionate customer. And so we cannot really wait until the third quarter to try to win her back. And so there are lots of things that we're doing to ensure that we are speaking their language.

We know what is important to them right now. Value is important to them. We are also looking at opportunities within our loyalty program to maximize our CRMs. You're going to see that rolling out in the third quarter. And there will be some nice benefits there that will incent them and hopefully take away the reason to shop at any of the competition. And so absolutely we're thinking about those things. We know that anytime you disappoint the customer, it has a long-lasting effect. And so we're doing everything we can to minimize that. And that is why anything that we feel we're not 100% happy with, we're not charging full price for it. And so we will make sure we leverage our events and our loyalty programs to speak their language in a time that value is very important to them.

Marni Shapiro – The Retail Tracker

Right, and I will follow-up with some of the other questions that are smaller on this offline. But I have one housekeeping. For '09 did you talk about any stores that you plan to close? I'm sure you close a handful of stores every year. But as leases come up, can you just give us an update there? And any stores you plan to remodel? Are any expansions, or they just all straight remodels?

Matthew McCauley

We have some remodels. We actually had pushed some from the previous year that we're going to do this year, and we pushed some from this year to next year. We have seen some nice improvements in sales in those stores that we have remodeled. We've got a new store design that we're very proud of that we actually have nice build-outs, nice build-out costs on those, seeing nice improvement in sales on those. So we are happy about rolling those out.

In terms of closed stores, we did not really speak to the number for the full year. Not anticipating a large number of stores, maybe a handful like you said. But as we get more information on those, we will certainly communicate that.

Marni Shapiro – The Retail Tracker

Right. Thanks, guys, and good luck getting through this.

Operator

Janet Kloppenburg, JJK Research.

Janet Kloppenburg – JJK Research

A couple of questions. First, just for my edification, when did you – in what press release did you first start telling us that you were going to be having charges against – charges related to these new regulations?

Blair Lambert

What we said in the January sales call was that we had some questions about the CPSIA and that the cost was included in our estimates at that time. (inaudible).

Janet Kloppenburg – JJK Research

There was never a press release prior to that time? Is that right?

Jeff Harris

This is Jeff. I mentioned it on the recorded calls both after December and after January that we were going to be in compliance, we intended to be in compliance with the regulations as they became effective, and that any impact was going to be embedded in our guidance.

Janet Kloppenburg – JJK Research

Okay. My next question is if you could elaborate please on the amount of changes that have been made in the vendor structure as a result of this? And just in your judgment, what kind of disruption that could cost going forward, i.e. we don't know these vendors? We have late deliveries now. Perhaps we have late deliveries later or perhaps we have quality issues, etc. etc. etc.

Matthew McCauley

Okay. I want to make sure we are clear on that. We have not made any major vendor changes. We made component changes, and again, those are temporary changes as I mentioned –

Janet Kloppenburg – JJK Research

There have been no changes in your vendor structure?

Matthew McCauley

There have been some changes in the vendor structure as a part of our ongoing sourcing strategy. That has been going on for the last four years.

Janet Kloppenburg – JJK Research

No, no, I'm talking about in relation to this issue.

Matthew McCauley

That is correct. No changes.

Janet Kloppenburg – JJK Research

There have been no changes in your vendor structure. So your vendors have then just begun to produce the product in a different way?

Matthew McCauley

That is correct.

Janet Kloppenburg – JJK Research

Okay. So the late deliveries were then because you made changes to what the component regulations were as you were going through this process?

Matthew McCauley

That is correct.

Janet Kloppenburg – JJK Research

Okay. And then how sure are you that this problem will be resolved at the end of the second quarter? How sure are you that there will not be a trickling in of incremental problems as we move into the back half?

Matthew McCauley

We are very confident in everything that has been communicated at this point, that we are compliant and have done everything we can to be compliant with what has been communicated at this stage. So there is always the risk that something new could come up, and depending on the time they give you to react, that is always the risk.

Janet Kloppenburg – JJK Research

When did you put the third-quarter receipts to bed, Matt?

Matthew McCauley

When did we put the third-quarter receipts? Third quarter –

Janet Kloppenburg – JJK Research

When did you book the third-quarter product that is coming in for third quarter, when would you have booked that?

Matthew McCauley

For this year?

Janet Kloppenburg – JJK Research

Yes.

Matthew McCauley

That is right around November, December.

Janet Kloppenburg – JJK Research

Right. So why wouldn't the same issues that are confronting the first and second quarter in those products since you learned of these changes in February, why wouldn't those issues be affecting you now for those receipts that were booked then?

Matthew McCauley

Are you talking about for our third quarter this year?

Janet Kloppenburg – JJK Research

Yes.

Matthew McCauley

Because we knew a year and a half in advance that they were going to lower the standards.

Blair Lambert

In August.

Matthew McCauley

So we knew it back in August that they that they told us ahead of time that in August a year from then they were going to lower the standards at that point.

Janet Kloppenburg – JJK Research

For the second half of the year?

Matthew McCauley

That is right.

Janet Kloppenburg – JJK Research

But not for the first half of the year?

Matthew McCauley

No, they said for the first half of the year, but not – but they had also told us for August of 2009 that they were also going to reduce those limits.

Janet Kloppenburg – JJK Research

Okay. So you were prepared for that?

Matthew McCauley

Much more notice, that is correct.

Janet Kloppenburg – JJK Research

Okay. And what percentage of the product that is coming into the second quarter would you say experienced disruptions in terms of having to make changes to the product and the finish and the detail and the trim?

Matthew McCauley

By May, we feel like that we have got lines that are inline. Really the impact to the second quarter is our lower inventory levels and the fact that we have got product that is still carrying over that was impacted.

Janet Kloppenburg – JJK Research

And maybe if Kip could help me a little bit. It sounds like there is a lot of weakness in girls, which I think comes from the outfitting. But I'm also sensing in you that perhaps the styles don't have the same familiarity, the Signature of Gymboree, what the customer is looking for in your line. Maybe you could talk about why that might have happened exclusive of these product recall issues and perhaps what happened there and how it is being resolved.

Kip Garcia

Yes, I think that actually outfitting actually was on a few of our lines in the fourth quarter was actually our biggest issue. There was one line that we delivered after that pink and brown line that was really bright colors, and it was a really fun line. But we found that as some of our customers in the store tried to put outfits together, that they were having trouble with that really very simple classic mix and match opportunity.

So we are just being really – we are really not taking the economy as an excuse for ourselves, and we are just digging deep into what we can do to make our assortments even better. And we do feel like that mix and match factor is the one thing that we can really, really improve. After that, though, what is really killing us right now is that we just don't have that sparkle that we had before, and we're going to be able to actually turn that around by May. The May receipts were designed into that.

Janet Kloppenburg – JJK Research

Okay. And Matt, you don't think that there's any problem with the consumer feeling that there is a credibility issue with the safety product at Gymboree? That there has been no – has there been any feedback from any consumer groups or from any consumers that suggests that there is a lower level of trust with your brand in families across the country?

Matthew McCauley

Actually we have had quite the opposite. We have had people very, very impressed that we have gone to the lengths and efforts that we have to ensure that not just the product coming down the product pipeline but the product that we had in our stores regardless of how long it had been in the stores, that we had gone to such great lengths to test and assess that inventory.

Janet Kloppenburg – JJK Research

Okay. And just my last question, I hate to ask so many, is, if you could just detail again if you feel that the higher product costs that will go into this quality assurance, can be made up for by a change in sourcing, which is kind of confusing to me because we have already heard that you have not changed any of your vendor structure.

Matthew McCauley

The vendor structure has not been changed related to change in components to this regulation changes. So let me be clear, we have changed vendors through a normal ongoing sourcing strategy. So your question earlier was whether or not we had changed vendors related to the regulations, and that is not true. We have changed vendors over time as we have gone into new countries and sourced better prices. So that is how we are offsetting the increased costs of testing.

At the same time, there's always opportunities to negotiate the cost of testing, and there's always competitors out there hungry to take more of that testing business. So yes, there are pressures on that, but at the same time, we are actually looking for savings and exploring other third-party testing companies at the same time that we are, as we've mentioned earlier, reaching out to new countries and new partners to reduce cost of goods.

Janet Kloppenburg – JJK Research

Okay. Thanks very much for your time, and I want to wish you all lots of luck in resolving these issues.

Operator

Rob Wilson, Tiburon Research.

Matthew McCauley

Rob, you there? Okay, let's move on.

Operator

Bill Dezellem, Tieton Capital Management.

Bill Dezellem – Tieton Capital Management

Actually I had two questions. The first one is the implications of you not opening any Crazy 8's in the first quarter, what should or should we not read into that?

Matthew McCauley

You should not read anything into it. We get obviously – it makes a lot more traffic and demand in the back half of the year. So it works out well for us to open stores right around the back to school time period, and that is where – that is the ideal place for us to open stores. If you cannot get them open in the first quarter, we definitely don't want to open a bunch in the second quarter and try to cluster them around where we have more traffic with the back to school time period.

Bill Dezellem – Tieton Capital Management

Thank you. And then the second question was somewhat coming at it from a little different angle before, but to what degree do you feel that there is a risk that your customer's perception of your merchandise selection has been hurt? Having no – many customers presumably would have no awareness of the safety regulatory issues. And, as a result, they just come back to the store less often, and so when the inventory is not in good shape again, they don't know it. They are just not coming back as often.

Matthew McCauley

Yes, that is always a risk that you are always concerned about and worried about. And so that is one of the reasons that we have not pulled back on our marketing efforts at this stage. We have a very loyal customer. We have customers that are looking for the latest and greatest. The advantage of delivering new deliveries every two to three weeks, it creates a lot of excitement and interest in the customer. So fortunately it is a relatively short-term impact to the product. May we feel much better about the product going forward. And we will continue to invest in marketing to incent them to come in and reach out to them so that we can get this behind us.

Bill Dezellem – Tieton Capital Management

Thank you.

Jeff Harris

Christy, have we got time for one more call?

Operator

Yes. Rob Wilson.

Rob Wilson – Tiburon Research

I want to go back to – you issued a sales recording. I guess Jeff put out the sales recording every month. And on January 8, you said that the standards we set for our products meet or exceed those set by the CPSC and applicable state laws. Given what we have heard today, was that a truthful statement at the time?

Matthew McCauley

Absolutely.

Rob Wilson – Tiburon Research

Okay. So reconcile that statement versus what you have discussed today.

Matthew McCauley

So basically the law changed and was in effect on February 10, and we were absolutely compliant by February 10. That was the timeline given to be compliant, and we did absolutely everything humanly possible to be compliant. And so by February 10, we were compliant. Prior to February 10, we were compliant with all of the laws and state laws and regulations in place at that time.

Rob Wilson – Tiburon Research

Okay. So you were not referring to historical compliance? You were referring to the current compliance and go forward compliance?

Jeff Harris

Compliance changes based on the timing of the delivery. So for any delivery we were bringing in, we have been compliant. And then to the extent that those rules change, we pull product off of the floors so we continue to be compliant.

Rob Wilson – Tiburon Research

I got you. Okay. I mean I guess when I read that statement, I would have been led to believe that you were okay and this was not a material issue. I think that is where people are a little confused about why this is all quickly transpired today.

Matthew McCauley

I can understand that confusion. That makes sense when you put it that way. I think if you look at it from as we were getting information, we knew that we had a charge in the fourth quarter, and we had it included, and we notified you. We had no idea the impact that it would have in the first quarter until we started to see impact on the sales. February 10 was when the product was no longer in the stores, when we had changed product in the stores, and that was when we started to see the impact to sales. And that is why we pulled this call up. We did not feel like it made sense to wait any longer. As soon as we knew how big it was and got our arms around it, that is why we are on the call today communicating it.

Rob Wilson – Tiburon Research

Okay. And Blair, what was – switching topics here, what was the loss at Crazy 8 for the year 2008?

Blair Lambert

You know, it is in the range of 17. It is a hard number to get at precisely because there's kind of a lot of moving pieces, and we don't really allocate costs perfectly across every area. We use a lot of shared services. But directionally it is about $0.17.

Rob Wilson – Tiburon Research

Now at the start of the year, if you go back about 12 months, you would have initially said it would be $0.08 or $0.09. So what happened between 12 months ago and the end of the year that caused that loss to double?

Matthew McCauley

Two things. We were more promotional than we expected to be. The economy was a lot tougher. We competed when we did not really have the IMUs that we had hoped to have, and that brought our margins down, and we saw pressure on sales that we had higher expectations on sales.

So those are the two things that really brought the costs up. And as I mentioned before, we're seeing nice improvements in the IMU that we had hoped for last year. We're seeing them come up this year, and we're actually seeing the sales on the trends that we were hoping for last year.

Rob Wilson – Tiburon Research

Is there – could you give us any sense for when you think this chain could be profitable?

Matthew McCauley

We have not put that out there yet. That has been out – we're still shy of our three-year mark that we talked about with Janie and Jack and obviously a little different environment that Janie and Jack launched in. But the things that we are encouraged by is that the sales today given normalized IMUs we would have a nice positive four-wall contribution on those stores. So that is going to take some time to get the units and the quantities up there to get the IMUs that we want. But we don't have to significantly improve sales to get a nice four-wall contribution. We just need to get the units up so we can get the IMUs high enough to get the margins we want. Hopefully that helps.

Rob Wilson – Tiburon Research

Now, you had mentioned previously that you wanted to allocate more product to certain categories going forward. Have those changes been made?

Matthew McCauley

The largest change in inventories and styling is going to happen around the back to school time period this year, and that is kind of what we are focused on. The number of deliveries and flows has changed throughout 2009. We have increased the number of flows. We have increased the size of flows around back to school and around holiday that we were a little backwards on before. We have increased the number of baby flows. We have expanded that business, and you will see a distinct change in the styling around back to school time period that is a lot closer to where we launched. And so we are very excited to see that.

Rob Wilson – Tiburon Research

Well, thank you. Thanks for taking my call.

Jeff Harris

Okay. So, Christy, thank you, and thanks, everyone, for attending our call. If you have further questions, you can reach us at 415-278-7933. Thank you very much.

Operator

Thank you so much. This concludes our conference call for today. You may now disconnect your lines.

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Source: The Gymboree Corporation Q4 2008 Earnings Call Transcript
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