Deckers Outdoor Management Discusses Q1 2013 Results - Earnings Call Transcript

Apr.25.13 | About: Deckers Outdoor (DECK)

Deckers Outdoor (NASDAQ:DECK)

Q1 2013 Earnings Call

April 25, 2013 4:30 pm ET

Executives

Angel R. Martinez - Chairman of the Board of Directors, Chief Executive Officer and President

Thomas A. George - Chief Financial Officer and Principal Accounting Officer

Analysts

Omar Saad - ISI Group Inc., Research Division

Robert S. Drbul - Barclays Capital, Research Division

Erinn E. Murphy - Piper Jaffray Companies, Research Division

Scott D. Krasik - BB&T Capital Markets, Research Division

Randal J. Konik - Jefferies & Company, Inc., Research Division

Sam Poser - Sterne Agee & Leach Inc., Research Division

Eric B. Tracy - Janney Montgomery Scott LLC, Research Division

Howard Tubin - RBC Capital Markets, LLC, Research Division

Mitchel J. Kummetz - Robert W. Baird & Co. Incorporated, Research Division

Christian Buss - Crédit Suisse AG, Research Division

Camilo R. Lyon - Canaccord Genuity, Research Division

Christopher Svezia - Susquehanna Financial Group, LLLP, Research Division

Operator

Good afternoon, ladies and gentlemen, and thank you for standing by. Welcome to Deckers Outdoor Corporation First Quarter Fiscal 2013 Earnings Conference Call. [Operator Instructions] I would like to remind everyone that this call is being recorded.

Before we begin, I would like to remind everyone of the company's Safe Harbor policy. Please note that certain statements made on this call regarding the company's expectations, beliefs and views about its future financial performance, brand strategies and cost structure are forward-looking statements within the meaning of the federal securities laws. These forward-looking statements are intended to qualify for the Safe Harbor from liability established by the Private Securities Litigation Reform Act of 1995. These statements relate to the company's anticipated revenues, expenses, earnings, gross margin, capital expenditures, brand strategies and cost structure, as well as the outlook for the company's markets and demand for its products.

The forward-looking statements made on this call are based on currently available information, and because this business is subject to a number of risks and uncertainties, some of which may be beyond its control, actual operating results in the future may differ materially from the future financial performance expected at the current time. Deckers has explained some of these risks and uncertainties in its earnings press release and in its SEC filings, including the Risk Factors section of its annual report on Form 10-K, and its other documents filed with the SEC. Listeners are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date hereof. The company undertakes no obligation to publicly release or update the results of any revisions to forward-looking statements. I would now like to turn the conference over to the President, Chief Executive Officer and Chairman of the Board of Directors, Mr. Angel Martinez. Please go ahead, sir.

Angel R. Martinez

Good afternoon, and thank you to everyone for joining us today. With me on the call is Zohar Ziv, Chief Operating Officer; and Tom George, Chief Financial Officer.

As you saw from our press release, first quarter sales and earnings came in ahead of projections. The upside was driven primarily by better-than-expected consumer demand for the UGG brand in both our wholesale and direct-to-consumer channels. This was partially offset by some temporary softness in the Sanuk brand's international business due primarily to inventory buildup at some key distributors.

Overall, we are pleased with our start to the year and feel good about the strategic direction of our brands. For the UGG brand, sell-through of classics, as well as casual slippers and spring fashion boots performed very well in double digits on a weekly basis throughout the quarter at key accounts, buoyed in part by colder temperatures across much of the U.S. versus the same period a year ago. In addition, several new spring casual styles have sold extremely well as consumers responded favorably to our new introductions carrying more attractive opening price points. The Mara, the Inda and the Liza [ph] casuals are selling in double digits, all in the $70 to $100 retail price points. The brands' continued momentum following the solid end to 2012 further validates our belief in the strength of the UGG brand and the desirability of our growing product collections.

As expected, domestic wholesale was down compared to the prior year, but we saw improved selling of the spring line as many of our key accounts expanded their spring business following solid performances the past few years. Better-than-expected sell-through of boots did generate some reorders during the quarter. In Europe, prolonged cold spells helped fuel sell-through of classic during Q1, further reducing retailer inventory levels and boosting confidence in the brand for next fall.

From a selling perspective, wholesale sales were down in line with plan, however, we are selling the spring fashion sandals well, and boots performed well in Q1 with colder-than-expected weather.

Now to Asia, where Japan wholesale sales were driven by the growing popularity of our spring line combined with increased demand for cooler-weather fall product. Like the U.S., Japan had a longer winter this year, which helped improve demand for classic boots, particularly the shorter-length styles, early in Q1. As the quarter progressed and temperatures warmed, we witnessed sell-through of casual shoes accelerate, underscoring the progress we've made evolving the UGG brand into a more of a year-round brand in this region.

Turning to our retail division. Sales were ahead of expectations driven by the combination of a mid-single-digit comp increase and improved productivity for many of the new stores opened over the past 12 year -- 12 months.

By region, comps were strongest in North America, with the U.S. and Canada up mid-teens and low double digits, respectively. Building off of a good holiday season and helped by cold spring weather, the U.K. posted a mid-single-digit comp gain, while in Japan, comps were up low single digits. While down double digits, China comps have continued to show a steady improvement over the past few quarters, thanks to new merchandising and marketing strategies, as well as the inclusion of several new stores in the comp base. During the quarter, we opened one store in the U.S. and currently operate a total of 78 stores worldwide. For 2013, we still expect to open in the neighborhood of 30 stores, 2/3 of which will be in Asia, primarily China and Japan, with the remainder in the U.S. and Europe.

Now to the Teva brand, which grew in the first quarter despite the cold weather conditions. As we documented for several seasons now, our focus has been on transforming the Teva brand into a more complete outdoor footwear brand in order to increase its growing prospects and lessen -- its growth prospects and lessen its dependence on weather. Following some successful close to a product introduction over the past few years, I believe we developed the Teva brand's most advanced and compelling spring line yet, led by the new TevaSphere collection of trail runners and cross-trainers. The technology inside these shoes, which took several years to develop, emphasizes a first-of-its-kind spherical heel and pod-arch system, delivering a more natural point of impact, efficient transition and superior stability on varied terrain. The collection has helped us acquire additional self -- shelf space, expand price points and elevate the brand's position with a broader consumer audience. The combination of performance and stability found in TevaSphere's products is state of the art, and speaks to the innovation our organization is capable of bringing to market.

We haven't forgotten the brand's roots and continue to advance the sports sandal category with new offerings for this year, that includes the successful Tirra and Zirra sandals for women, and our Terra Fi light sandals for men. We did miss out on some replenishment business in Q1 as a result of the unseasonable cool temperatures, which could also have an impact on some Q2 deliveries. But overall, we're pleased with the brand start to the year.

The Sanuk brand domestically was a solid quarter, with sales up double digits versus a year ago. Like the Teva brand, the Sanuk brand lost out on some reorders as a result of colder weather, but still managed to achieve a mid-single-digit wholesale sales increase led by strong response to new styles such as the Yoga Sling sandal and dotty sidewalk surfer for women, and updated looks in our core sidewalk surfer for men.

The brand's eCommerce business continued to post impressive gains fueled by last spring's conversion to the Deckers platform, which allowed us to create a much more effective environment for engaging with consumers. We recently developed another new environment with our first company-operated Sanuk brand store in the U.S. located on 3rd Street Promenade in Santa Barbara -- Santa Monica. The store is in the heart of Southern California, home to the surf culture, from which the Sanuk brand was born, and one of the busiest tourist destinations in the country.

It's the meeting of these 2 worlds that serves as the basis for our strategy with the Sanuk brand. First and foremost, we must continue to connect with our core consumer who influences much of the U.S. market and other markets inspired by surf culture. At the same time, we need to expand the brand's conversion beyond the beach and evolve the product line to reach new audiences, while still retaining and maximizing our current audience.

Looking at the Sanuk brand performance overseas. First quarter sales were below last year, mainly due to declines in Asia. I believe much of the decrease can be attributed to the normal growing pains many young brands experience, as they make the transition from niche player into a larger market participant. Until now, the Sanuk brand relied solely on distributors to launch and grow the business in the international markets, namely Asia-Pacific. And with the formation of the Sanuk management team and Deckers' subsidiaries in Japan, we now have the infrastructure to take a more direct involvement in the Sanuk brand's operation throughout the region. So we're currently working very closely with some of our largest distributors to improve their inventory management and distribution strategies.

I'll now turn the call over to Tom, who will review the numbers in more detail and update our outlook. Tom.

Thomas A. George

Thanks, Angel. Today's earnings release contains a good amount of detail about our first quarter sales and earnings, including sales by brand, channel and geography. Therefore, I'm going to limit my discussion primarily to gross margins, operating expenses, the balance sheet and guidance.

Gross margins for the first quarter was 46.8% compared to 46% in the first quarter last year. The 80 basis point improvement was primarily attributable to a greater proportion of higher-margin retail sales in Q1 2013 as compared to the same period last year, which offset an increase in sheepskin cost.

Total SG&A expense for the quarter was $120.9 million or 45.8% of net sales compared to $101.4 million or 41.2% in net sales a year ago. The dollar increase versus a year ago was primarily due to $10.4 million of additional expense related to our retail operations, most of which is for the 29 new retail stores that were not opened during the first quarter last year as well as some additional marketing and international costs.

Operating income for the first quarter was $2.7 million or 1% of sales compared to operating income of $11.9 million or 4.8% of sales last year. The decline in operating margin was a result of the aforementioned increase in SG&A expenses.

Our effective income tax rate for the first quarter was 59.9% compared to 34.9% in the first quarter last year. The higher tax rate in 2013 was mainly due to onetime tax items, which had a higher percentage impact as a result of lower pretax income as compared to the prior year.

First quarter diluted earnings per share was $0.03 versus $0.20 a year ago and compared favorably to our guidance for a loss of approximately $0.12. The upside relative to our guidance was driven by the combination of higher sales, which was worth approximately $0.12, and approximately $0.03 was attributable to a delay in incurring marketing expenses during Q1 and then in -- will move into Q2, which will now be incurred in the second quarter.

Turning to the balance sheet. At March 31, 2013, inventory increased 23.3% to $257.1 million from $208.5 million at March 31, 2012, and decreased 14.4% from $300.2 million at December 31, 2012. The $48.6 million increase in inventory from the prior year is primarily due to UGG driven by a carryover of product, which will be utilized to fulfill orders during 2013. In addition, approximately $10 million is due to higher unit cost and $9 million is due to 29 more retail stores compared to a year ago.

By brand, compared to March 31, 2012, UGG brand inventory increased $42.5 million to $201.5 million. Teva brand inventory increased $0.5 million to $31.3 million. Sanuk brand inventory increased $3 million to $15.1 million, and our other brands inventory increased $2.6 million to $9.2 million.

I'd like to provide more detail regarding our comfort with the quality of our UGG brand inventory. At March 31, 2013, in-line and carryover products represented approximately 90% of UGG brand inventory. The remaining 10% is inventory available for our outlets or the closeout channel, and we believe has been valued appropriately and has been considered in our forward margin guidance. Regarding orders for in-line and carryover product, as of March 31, we have orders for a significant amount of inventory with the balance available for our retail stores in the eCommerce business, which combined, has grown to over 25% of our business. At March 31, 2013, our cash and cash equivalents were $64.6 million compared to $228.6 million at March 31, 2012. At March 31, 2013, we had $10 million outstanding in outstanding borrowings under our credit facility compared to 0 a year ago and $33 million at December 31, 2012. The decrease in cash and cash equivalents and increase in outstanding borrowings year-over-year are attributable to $200.7 million of stock repurchases over the past 12 months at an average price of $47.33 a share and $62.5 million of cash payments for capital assets, which includes $34.1 million of retail expansion, $13.6 million for the new headquarters facility with the balance of $14.8 million for IT infrastructure and maintenance, as well as other expenditures, offset in part by cash provided by operations.

During the quarter, we did not repurchase any shares of the company's common stock. As of March 31, 2013, we had $79 million available under the $200 million stock repurchase program announced in July 2012.

Regarding our retail operations for all stores opened at least 12 months at March 31, 2013, the average sales per square foot was $1,500. This figure compares to sales of approximately $1,600 per square foot for the trailing 12 months ending December 31, 2012 with a difference driven by addition of our Canadian locations as well as several China stores, countries where productivity levels are below the company average.

Total square footage at the end of March was approximately 215,000 square feet compared to roughly 134,000 square feet at the end of March 2012, representing an increase of about 60%.

Now moving on to our outlook. Based on first quarter results and current visibility, we still expect 2013 revenues to increase approximately 7% over 2012 levels. For the full year, we still expect UGG brand sales to increase by approximately 4%, and Teva brand sales to increase approximately 6%. We now expect Sanuk brand sales to grow approximately 10% to 13% compared to our prior guidance of approximately 15%, while other brand sales are now expected to generate $41 million in 2013 compared to prior guidance of $40 million.

With regard to earnings, we still expect diluted earnings per share to increase approximately 5% over 2012. While first quarter earnings did come ahead of guidance, a portion was related to a shift in the timing of certain marketing expenses. We are also seeing some pressure on earnings from fluctuations and foreign currency, primarily in the back half of the year. Finally, with such a significant amount of our earnings concentrated in the fourth quarter, we believe it is prudent to maintain our original full year outlook until we get closer to our key selling season. Our forecast is still based on a full year gross profit margin of 46.5% and SG&A as a percentage of sales of approximately 34%.

For the year, capital expenditures are still projected to be approximately $85 million with $40 million for retail stores, $30 million for the corporate facility, and the balance of $15 million for IT and other maintenance. And we are still planning to refinance our corporate headquarters by securing long-term financing.

For the second quarter of 2013, we expect revenues to be approximately flat with second quarter 2012 levels. As Angel mentioned, the cold spring weather, thus far, is likely to have an impact on reorders for the Teva and Sanuk brands, which is factored into our guidance.

For the second quarter, we expect a diluted loss per share of approximately $1.10, which when you take in account the $0.03 impact from the shift in marketing expenses, is in line with the Q2 guidance we outlined on the year-end call for a diluted loss per share of approximately double the $0.53 we lost in the same period a year ago. Looking at the back half of the year, it is important to know that based on the growing contribution from our own retail stores, combined with the change in wholesale buying patterns following 2 consecutive mild winters, we now expect roughly 85% to 90% of our projected second half earnings will come in the fourth quarter. I will now turn the call back over to Angel.

Angel R. Martinez

Thanks, Tom. So we're close to completing our fall pre-book, and orders have come in as expected, which is down compared to 2012. We saw a good response to our new transitional product highlighted by driving mocks, slippers and ballerinas, as well as specialty classics, slippers, casual boots and fashion boots. Retailers remain cautious on fall-winter deliveries, following back-to-back mild winters. We've seen this in our more weather-sensitive collections, namely cold-weather specific products. On a positive note, the cold first quarter helped further clear carryover inventory in the channel, improving the opportunities for reorders in Q4, should we experience a more normalized winter.

Now before moving to questions, we want to expand on our discussion about Pure. As we discussed in our last earnings call, our innovation team has delivered on a challenge that's been underway for some time, namely, to develop additional materials that would allow us to deliver the comfort for which the UGG brand is known, while helping to mitigate the unpredictability of material costs. The material is called UGG Pure, which is a wool pile textile, created by crafting wool fibers and weaving them into a durable backing that allows us to deliver a plush and consistent sensory experience. We're introducing UGG Pure into the footbeds and linings of some of our products beginning in April in our own concept stores, and in late May, in our wholesale channels. With UGG Pure, we believe that we'll be able to lower our product cost and pursue profitable new growth opportunities, some of which were previously not economically viable. As I said on the last call, UGG Pure gives us another important key to further unlock the lifestyle nature of the UGG brand well beyond footwear. While we're excited about the flexibility we believe UGG Pure can potentially provide, I think it's important to keep this development in context. We will expand UGG Pure into other products in our line over time. As a reminder, our classic collection is currently constructed using mostly premium twin-faced sheepskin, not tailor-grade sheepskin. So while UGG Pure will offer some near-term cost savings, we'll still be heavily dependent on sheepskin for the near term. We'll be able to update you on our expected sheepskin cost basis for fiscal year '14 when we report third quarter results in October. So thank you for your continued interest in Deckers, and we'll now be happy to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from Omar Saad with ISI Group.

Omar Saad - ISI Group Inc., Research Division

Angel, I wanted to follow up on your -- the comments you just made on the UGG Pure. It seems like this timetable may be moved up a little bit. It sounds like you have some of it in your own stores. If I remember correctly, I think in the last call, it sounded like it was more a fall collection development. Has anything changed in terms of the supply chain around that or your comfort level through consumer testing? Any kind of thoughts around that would be helpful.

Angel R. Martinez

Well, fundamentally, nothing has changed. We're getting better at refining our supply chain. Everyone is now growing more familiar and more comfortable with the processes involved in producing the material. We have said from the beginning that it would be infused into the product line slowly. Now some of these transitional product that you're going to see in stores beginning in this -- this April was a good opportunity for it to be introduced in the footbeds and some lining materials. So that's what we're doing. So no real change from what we originally said. You'll still see it at wholesale as we had planned in May and June.

Omar Saad - ISI Group Inc., Research Division

Got you. Understood. And then one quick question, follow-up on the fall. Your comments around the fall orders, the second consecutive warmer winter. As expected, there's some softness there as retailers are being more cautious, and it sounded like it was mostly in the kind of colder weather lines. Are there other -- any other areas in the product lines where you're getting a retailer response that you're a little disappointed by that you're going to focus on developing further in the coming years? Or perhaps some areas in the line where Pure could play a role?

Angel R. Martinez

I don't think anything has come as a surprise. I think people have just been generally speaking cautious. I think that they have been a couple of things. It's not just a warm winter that's the impact of all the eCommerce that's going on across all channels, across really all consumer industries. So we're seeing that across the board. That's why a couple of years ago, we really started to diversify our classic assortments, so it was not so monolithic, if you will. Some of the updated classics, some of the new classic derivative product that we've done has added a lot of new interest. It allows us to do more marketing driven around product that's only available for a short amount of time as we did last holiday season. So no, I'd say generally, there's no surprise. People -- the cautiousness is pretty consistent. Interestingly, I think you'll see as a result of the cooler weather this spring, it should -- people may look at their order book and realize that perhaps if we start to trend toward a more normalized winter that they may be a little short on even-core classic product and core colors, but it's too early to tell that. We'll find that out as the season progresses.

Omar Saad - ISI Group Inc., Research Division

Have the retailers had any response to Pure? Is that reflected at all how they responded?

Angel R. Martinez

We've had tremendous positive response to Pure. I think in the end, the consumer is really being offered a product that's improved and better. So it actually enhances the UGG experience at retail. So the retail as we've had in and showed them the material. And, a, they blind test, they say, "Well, I like this one. It feels better to me." And they find it's UGG Pure. So in many cases that we've shown it to people, that's been the response.

Operator

And next is Bob Drbul with Barclays.

Robert S. Drbul - Barclays Capital, Research Division

I guess the first question is on the order book -- I'm sorry, on the inventory levels, I think you said 90% of it is in line. Like how much of that number -- can you give us a number in terms of how much of it has orders behind it right now as you head into the fall?

Angel R. Martinez

Yes, Bob, that -- I even commented that on the script. A significant amount of that already has orders. And we also -- that inventory also supports our direct-to-consumer business as well. So we feel like we've made good progress in getting the inventory levels more in line and feel really comfortable looking at that inventory and the quality of that inventory on a very detailed basis relative to what we've pre-booked.

Robert S. Drbul - Barclays Capital, Research Division

And then on -- and then for the rest of the year, I guess from the first quarter, you talked about more attractive price points. Just a similar question, but do you feel like you have the pricing piece of this in a good position for the rest of the year, both on orders but at retail?

Angel R. Martinez

Yes, we do. We feel that we're in a good situation there. One of the things that helped us even get more and more comfortable is that with that colder winter that we experienced the first quarter of the strong sell-through we saw at the classic products in the first quarter with our major customers, that even reinforced further that we feel really good we're at from a pricing point of view.

Thomas A. George

Yes, we experienced no price resistance with core product in the first quarter. We really feel that -- and just sort of validates what we've been saying about the brand. The brand has tremendous power in the consumer environment. And normalized winter creates significant demand increases as we have seen just in the example of this colder spring.

Operator

And moving on to Erinn Murphy with Piper Jaffray.

Erinn E. Murphy - Piper Jaffray Companies, Research Division

I just wanted to follow up. It was helpful to hear that comp detail by region. If you could just help us kind of put some of the key regions in the North America, Europe and Japan in context of last year. And then as we go forward throughout the year, where do you see the biggest opportunity in terms of the regional performance? That's my first question. I have a quick follow-up.

Thomas A. George

Yes. We were pleased with how the comps performed during the first quarter. I mean, we talked about there's still some challenges in China. I think we've made great progress in identifying what we need to do there in China from a store operation point of view, and in inventory management within the stores. In addition to -- from a merchandising and marketing point of view on the stores, we experienced good traffic increases in the stores during the first quarter. But one thing to keep in mind on the comps is there's still -- we're still relatively new to retail and the comp base is still relatively small in the scheme of things. So it is subject to some volatility, especially in the regions that have a smaller number of stores, and that being Japan. So I think net-net, because it is still very early, and really the results for the year are really fourth quarter driven and they're very direct-to-consumer oriented kind of results, we're still assuming some caution in the comps. And until we get to the fourth quarter and still then, we're even looking at trying to be cautious at this early stage of the game.

Angel R. Martinez

And as far as your other -- the other part of your question, we're very excited about opportunities in Asia with our brand. One of the things that we've learned is to be much better merchants. So the merchandising of products of Dave Powers and his team has brought forward is going to make significant impact, already has been making an impact. UGG Pure is going to allow us to evolve and develop product that is a little bit more attainable for a broader percentage of the population in China. Because right now, we're really looking at products that's only available to the top 2% or 3% of the population from a price point of view. It's leaving too big a gap below us that knockoff brands are exploiting. So this is going to be an opportunity for us to really exploit that opportunity, that potential in our brand, and we're pretty excited about that.

Erinn E. Murphy - Piper Jaffray Companies, Research Division

That's really helpful. And then, I guess, Tom, just a quick last follow-up for you, on the Q2 revenue guidance and can you appreciate the dynamics given the deferred spring selling season with both having Sanuk, but how should we think about the revenue component for the UGG brand? And just help us maybe appreciate the channel dynamics between retail wholesale in the second quarter, and that would be really helpful.

Thomas A. George

Right. I mean, second quarter is sort of the most insignificant quarter, really. It's -- most of the spring product is really sold into the first quarter, so that remains. The second quarter is some closeouts are involved in the second quarter. And retail is very low in the second quarter as well. So we -- that I have given you a little bit more flavor not only with Teva and Sanuk, but Teva and Sanuk are sort of flattish at best that the UGG domestic wholesale is planned to be a little bit down from a comp perspective. Any gains from a channel perspective, we expect comps to be sort of flattish, maybe slightly up. We have seen some improved productivity on the new stores. But the declines I described in the wholesale and the distribution channel, that's going to put some pressure. So net-net-net, it all boils down to sort of flattish, a flattish quarter from a top line point of view, and so that's that.

Operator

And next will be Scott Krasik with BB&T capital.

Scott D. Krasik - BB&T Capital Markets, Research Division

Tom, I just wanted to clarify your comment based on the $0.03 you did this quarter and the minus $1.10 in the second quarter, that would imply about $4.70 or so in the back half of the year. And then you said only 10% or 15% of that would be in Q3?

Thomas A. George

Yes, that's right. I mean, there's a lot of different dynamics gone. More retail stores, and we also talked about there's more and more of a shift with our major wholesalers to order more product for the fourth quarter versus the third quarter. I think and another dynamic there is we are moving to try to get more of our retail stores opened in the third quarter, not have them all piled into the fourth quarter. So -- and given the third quarter is not that strong of a retail quarter, you get some more SG&A that you need to absorb in the third quarter. And I think one other thing, pretty important thing, is from a margin perspective, there's really no benefit we're seeing in the third quarter relative to the sheepskin and the Pure savings we're going to experience this year. That's really a fourth quarter phenomenon. So that puts -- that really skews the back-half earnings numbers.

Scott D. Krasik - BB&T Capital Markets, Research Division

So Angel, I guess, your order book closes, I think, the end of April, I'd heard. Do you see orders sort of move from Q3 to Q4. Do people just eliminate the orders from Q3 and keep the orders the same for Q4 and then expect one's business? How does the order book look? As it's almost closed, I think.

Angel R. Martinez

I think we're seeing a slide more toward Q4. I think we're seeing people are willing to roll the dice on inventory availability in Q3 if they haven't stepped up and ordered as aggressively as they had in the past. If the winter season kicks off aggressively, they'll be chasing inventory. And we'll be fulfilling a lot of orders on our eCommerce and our own stores. So we're just seeing a shift now with retailers wanting to be much closer to market, which is a little ironic because it wasn't that long ago that you'd see a fall product in full bloom in July. Lots of merchandise. I think you're going to see that big shift away from that at retail.

Scott D. Krasik - BB&T Capital Markets, Research Division

So if I could just sneak one last one in. And you talked about transitional product last quarter. I guess 2013, you just didn't have enough time. But what type of product can you create to get some of that Q3 business back in wholesale?

Angel R. Martinez

Well, we do have some transitional products shipping this year, and we've really began that last year. It's really about the weight of the material, the components of the material that make it more winter-appropriate versus fall-appropriate. Driving mocs are important as a transitional product. The ballerinas are important as a transitional product. Sandals, still obviously, important in the first half of Q2. So we've got more diversity of product, more colors, more materials. Wedges are important. All of that stuff is something we're been building, and it's been well received and selling through quite well. So we'll be doing more of that.

Operator

Next will be Randy Konik with Jefferies.

Randal J. Konik - Jefferies & Company, Inc., Research Division

I guess, Angel, can you give us some perspective on the ultimate -- and when you look, when you think about the inventory on the wholesale channel distribution, where do you feel like it's cleanest from a geographic perspective? That's my first question.

Angel R. Martinez

I think anywhere we've had cold weather this spring, which is Europe, U.K. particularly, the U.S. and Asia as well. Japan had cold weather in the first part of spring. So in all of those markets where we had carryover product from Q4, that will have a positive impact. I mean, certainly, it was inventory that a lot of retailers already own, but it bodes well for what we have in terms of their needs for Q4. So they're much less concerned about that aspect of their UGG business, given what happened with the weather in the first quarter in those key regions.

Randal J. Konik - Jefferies & Company, Inc., Research Division

Got it. And then second question is, in terms of the product that we're going to be looking at from a fall-winter perspective in 2013, what would the consumer or which, from a sell side perspective, which -- what kind of product should we be noticing the most in terms of incrementally impacting demand, i.e. they'll pop with the consumer, et cetera. What are the wholesale customers getting most excited about right now?

Angel R. Martinez

Well, what we think we've done around classic, I think, are very exciting. And classic is almost -- you sort of have to think of it as a design theme versus specific product assortment. It is a classic-inspired product. So it's really kind of takes what people love so much about classic, and evolves it with material upgrades, and colorways and treatments. The whole variety of things that make it very unique and unusual compared to what people have seen in the past. So that's pretty important. The casual boots are very important. There's a lot of excitement about that. We've got good price points on those products. I think we've done a good job with the right style and assortment. Our men's product for fall is quite strong, especially the boots. So it's -- and by the way in the fall, we've sold a lot of sneakers. I mean, the beginning of the fall, that's been -- continues to be pretty strong. So it's a much more diversified product line. Now, given the last 2 years of mild weather, we really haven't been doing a lot of aggressive development of more cold weather product, what we'd call cold weather product, because obviously there, you got a one-shot deal there. And our core styles in cold weather have performed well. It's just that there hasn't been enough cold weather to go around. So we've just evolved those appropriately but haven't evolved the amount of SKUs in those assortments.

Randal J. Konik - Jefferies & Company, Inc., Research Division

Got you. And I guess last question would be more for Tom. Tom, if you go back a little while ago when you guys had leveraged the balance sheet and used it to aggressively repurchase $200 million or so of your stock over the last 12 months, you had $79 million left to buy back. You're going to have generated a ton of cash in the back half of the year. The business seems to be stabilizing. Could we expect you to get more aggressive once again from a share repurchase perspective? How should we be thinking about that?

Thomas A. George

I think the best way we can comment on that right now is just refer to the current authorization. We do have $79 million remaining on that authorization, and we will look to continue to be opportunistic. And you're right, the company, the business model does generate a significant amount of free cash flow. And that being said, we've got a significant amount of opportunities that we want to reinvest in the business. So can't comment on any -- well, that's all about I can comment on, relative to share repurchases.

Operator

And moving on to Sam Poser with Sterne Agee.

Sam Poser - Sterne Agee & Leach Inc., Research Division

A couple of questions. Number one, you mentioned that the backlog was down. Can you give us some indication of -- you gave it on the first quarter. You said the backlog was down 17%. Could you let us know what's going on this quarter?

Angel R. Martinez

Sam, we feel good where the prebook came in and it is down, really, in line with our expectations, and it gives us a lot of comfort in terms of how we're guiding for the back half of the year.

Sam Poser - Sterne Agee & Leach Inc., Research Division

What I'm trying to get to is last year a lot of the retailers were sitting on a good deal of inventory. And this year, I believe the inventory levels are cleaner at retail. So I was wondering sort of what percentage of the backlog that you've had at this point last year that you actually shipped to try to get a read on basically how stick -- if the backlog you have now is stickier, you could be ending up in better position.

Angel R. Martinez

Good question. A year ago, what eventually happened in the back half of the year, especially the fourth quarter, we did experience some significant cancellations. And we also commented on the call, we've seen that the inventory in the channel is a lot cleaner. And all that being said, this early in the year before the key selling season, we still think it's prudent to maintain a similar percentage level of cancellations to last year in our guidance.

Sam Poser - Sterne Agee & Leach Inc., Research Division

All right. And then secondly, you mentioned on the prior call that you expected inventory at the end of the second quarter to be around $300 million and be down on a year-over-year basis. Is that still what we should be looking for?

Angel R. Martinez

Yes, I think one thing to point out on inventory is, there's been a lot of moving dynamics. The business is changing. A lot more direct to consumer business that needs to support. There's more transitional products, more stores. There's higher sheepskin cost. The factories are after us to take more product earlier. That said, at the second quarter, we still expect the inventory to be down compared to the prior year and flattish to that year-end $300 million number.

Sam Poser - Sterne Agee & Leach Inc., Research Division

Okay. So that's still -- nothing's changed with that at all?

Angel R. Martinez

That's right.

Sam Poser - Sterne Agee & Leach Inc., Research Division

And I've just -- one last thing, because a lot of people are asking me this question. It was basically, you had $208 million at the end of last year at the end of the first quarter. If you were to aim even close to that number and be down, you wouldn't have brought in any new product, because it would have been logistically impossible. Am I just thinking about that correctly?

Angel R. Martinez

I think related to the first quarter, we're pleased with the progress we made.

Sam Poser - Sterne Agee & Leach Inc., Research Division

No, I understand that. What I'm saying is, is that people are saying, "Wow, your inventory is still up. It's up more than it was at the end of Q4." And my point is, is that, just in pure dollars, you couldn't have gotten it even close to that number or you wouldn't have had any new product to sell. Am I thinking about that correctly.

Angel R. Martinez

Right. No. You are thinking about that correctly, that's...

Operator

.

And moving on to Eric Tracy with Janney Capital Markets.

Eric B. Tracy - Janney Montgomery Scott LLC, Research Division

I guess if I could follow on the UGG Pure conversation. One, just -- are we able to get a sort of percentage of potential penetration by, say, holiday this year? What's expected?

Angel R. Martinez

As we've said, we're -- because of the evolution of the supply chain, we're going to be introducing it in footbeds and some lining materials in 2013. We have sheepskin lining material that we own from prior years. So I wouldn't expect it to be much more than 10% of what we're using. It will formally be a conventional lining material. Over time, I would say that our near-term goal is 25% of the lining material to be replaced by UGG Pure, I mean 25% of our sheepskin used to be replaced by UGG Pure, which would represent about most of the lining material that we're using.

Eric B. Tracy - Janney Montgomery Scott LLC, Research Division

Okay. And just to clarify, again, how you're thinking about layering in the UGG Pure. On the core classic, obviously, will just be the footbed. Is it my assumption that you try to maintain the pricing level within the classic and, obviously, just layer in the lower product cost, so that the margin beneficial, very helpful. But then on some of the more fashion-oriented newer lines, they could actually be the full silhouette in the lining of the product, and that gives you an opportunity to adjust pricing down. And then I guess with all of that then, can you give any sense of just like-for-like, what sort of the lower product cost might mean to margin?

Angel R. Martinez

Well, first of all, over time, yes. The new product, where we have an opportunity to utilize more UGG Pure in the design of the product and what it delivers to the consumer, you'll see a higher percentage of the new product in the UGG Pure material. As I said before, it is superior. And so that's important to understand. Classic will remain, for the near-term, prime twin face. It's still, I think, a little bit early to sort of discuss what the ultimate impact is on margin, but we're going to be driving as aggressively as we feel appropriate to use UGG Pure as an essential part of what makes UGG feel like UGG, feel like nothing else. And that in and of itself, the consumer is going to vote. The consumer is going to vote. Do they like it better? As we think they do, they will. They'll demand more of this feeling and more consistency of product and it's going to give us opportunity to introduce new product at better margin and even at lower introductory price points, so that we can go get back some of that core customer that we lost due to price increases over the last few years on the raw material.

Eric B. Tracy - Janney Montgomery Scott LLC, Research Division

And then just lastly on the UGG Pure, is it fair to say, even if you get to that 25% near-term penetration level that the byproduct should actually cause some downward pressure on the twin face sheepskin market correct? In pricing?

Angel R. Martinez

I think, theoretically, that you could see that happening. Yes, I think so. But we're always going to be in the market for a prime twin face. It's important, we feel that there are some products that consumers just want them the way they are, and we're not going to go changing them. But this is really about product evolution and the new opportunities it creates. And as we evolve some of the new categories that we haven't been in, such as home products and apparel, et cetera, you'll see more use of this material. And over time, it should have a positive impact on price of the conventional table grade material for sure.

Eric B. Tracy - Janney Montgomery Scott LLC, Research Division

Okay. And then if I could just squeeze one last in, just switching gears here towards the retail growth. I think there's probably half of the stores switching in the stores. The 30 this year are going to be in China. And maybe just talk through, again, the weaker comps now, I know there was an issue just around fit and sizing and also some operational issues. Just talk us through the comfort level that you have in improving productivity levels. And then it's my understanding relative to the rest of the fleet, China does have the best profitability. So just trying to get a comfort given how aggressive you're sort of ramping those relative to some of the weaknesses you've seen in the past.

Angel R. Martinez

Yes, Eric. I mean, and some of that, the things we talked about, improved productivity and what's going to drive that, some better merchandising, better flow of product and some more marketing, getting the consumer more and more aware of the value of a real UGG versus a down market product, and some changes from a store management point of view and sort of a more senior retail management point of view in China. And I think those are going to really -- they'll just give us more and more comfort in the continued learnings we have there, that we're going to be able to turn that around and continue to gain some improvement. We did mention, we've been seeing some steady improvements on our retail store operations in China. And we're still just scratching the surface of the total opportunity there. When you look at second, third tier cities, you look at outlet concept opportunities. That is still a great opportunity. In terms of productivity, they are smaller stores. They still generate 1 year kind of paybacks, which has very strong returns on invested capital, but they are smaller stores compared to some of the U.S. and European stores.

Operator

.

Moving on to Howard Tubin with RBC Capital Markets.

Howard Tubin - RBC Capital Markets, LLC, Research Division

As you continue to develop Pure and you introduce some more maybe lower price point or entry level price point items into your brand, should we expect to see any new or different distribution or you keep kind of distribution channels, in terms of department stores, where it is today?

Angel R. Martinez

I think you'll see us remain pretty consistent with where we are today. Actually perhaps even slightly down in terms of our distribution. Outside the U.S., obviously, China is a retail-only market, so you'll see us be able to talk to more consumers. As I said earlier, 2% to 3% of consumers in China have access to the UGG brand because of the price points. So it'd be great to get another 3% or 4% of the population able to buy UGG. So that's important. The other thing about China is that there is much known about 170 cities, a population over 1 million people, and we haven't even begun to penetrate those markets. So there's opportunity there. I think what we are really looking at is the revolution going on called Omni-channel, which really begins to create a different mindset, if you will, for our consumers. They want to access brands, how they want, when they want. And many of them either do their initial shopping online and go buy in a store or they just only buy online. Yes, in footwear, we're all very fortunate that -- it's an experiential kind of purchase. So you got to go try something on, which brings people out in the stores, is very important. But the impact of Omni-channel over the next few years is going to continue to be a factor in distribution decisions. So my guess is that when the customer realizes they can buy a product online 24/7, a product they know and are comfortable with and they prefer to shop that way, it probably means you don't need that many more points of physical distribution than you currently have. So that's just sort of my theory. And I think so far, it's been validated by what we're seeing.

Operator

Moving on to Mitch Kummetz with Robert Baird.

Mitchel J. Kummetz - Robert W. Baird & Co. Incorporated, Research Division

Angel, you've talked about how the cold weather has led to a reduction of carryover inventory at retail. So I'm just trying to understand as that sort of process has transpired over the last few months, I mean, as you look at your order book, do you think that, that's prompted retailers to be a little more aggressive with their orders and maybe what you thought they would have been 2 or 3 months ago before we saw that cold weather? Or did that just -- or retailers kind of just sitting on what orders they thought they were going to write and then that just better positions you for the opportunity for kind of at one's business later in the year.

Angel R. Martinez

I think the latter is true. I think what people are doing is just feeling, breathing a little easier with the amount of inventory they have on hand. Rolling the dice and saying, you know, if I need inventory, more inventory than I have planned, I'm just going to -- I'm going to hope UGG has it and I'm going to hope to get that from UGG when I need it. That may or may not be true. And if we see a cold snap early, that may not be the case and they may be chasing inventory. So I think it's this cautiousness, yes, it's weather-dependent to a large extent, but it's also, as I mentioned, it's dependent on Omni-channel. I think people are just very cautious as to what's happening with all this stuff. How much inventory do we really need? And they're saying to themselves, do we have to carry all this inventory? Can't the brands carry this inventory for us? And obviously, that's not my preference. We're not a warehouse for people. So our priorities will be to service those customers that step up in the pre-book, certainly, service our own stores and our own eCommerce business. And if there's any product left over, we can ship it to other people.

Mitchel J. Kummetz - Robert W. Baird & Co. Incorporated, Research Division

You guys have been pretty consistent the last couple of quarters saying that the guidance assumes a similar level of cancellations as a year ago. To me that would seem to be a more conservative assumption today than maybe 2 or 3 months ago before we had this cold weather and this reduction of carryover inventory. Is that a fair assessment of that assumption?

Angel R. Martinez

I think that's a fair assessment. I mean I'm comfortable being conservative when it comes to the weather. No one has a very good crystal ball on this stuff yet. We don't know if there's a pattern. No one does.

Mitchel J. Kummetz - Robert W. Baird & Co. Incorporated, Research Division

Yes. And then to Tom, I don't want to take up too much more of you guys time, but I think coming off the last earnings call, you had talked about just sort of a flat comp on the year and then U.S. UGG wholesale sales down, mid to high single digits. It doesn't look like your sales earnings guidance has changed for the year. So do those assumptions still apply, as they did coming off the last quarter?

Thomas A. George

Yes, they do. I think that's a good way to look at it. I mean, we have really no change to the outlook in the back half of the year for the UGG brand.

Operator

.

Moving on to Christian Buss with Credit Suisse.

Christian Buss - Crédit Suisse AG, Research Division

If you could provide some perspective on some of the moves you've been making to reposition UGG brand in Continental Europe and what kind of success you're seeing there and how much is left to do?

Angel R. Martinez

Yes, it's-- I don't know that I would use the word reposition. I think what we've really done is a couple of things. Number one, we cleaned up the distribution, which allowed us to more effectively control the assortment and the mix that's available at retail. We broadened the product assortment, so that with the distribution partners that we have now, we're able to make a much better statement of what the brand is and what it is on a year-round basis, what it is for men and women and kids. So I think we were pretty one-dimensional before. It was pretty much driven by classic a couple of years ago, and I think we've been making wonderful progress along these other dimensions. So it's created for the consumer a much better understanding of what UGG is and a much more -- a sense of the appropriateness of the brand for a much broader, much bigger part of the year. So I really think that, that's been the fundamental strategy, and it's working quite well.

Operator

.

And moving on to Camilo Lyon with Canaccord Genuity.

Camilo R. Lyon - Canaccord Genuity, Research Division

I just wanted to ask a question on Pure. How do you guys think about the risk of cannibalization since you're -- it sounds like you're keeping the distribution channels the same and it seems like this will be a lower-priced product. How do you manage that potential risk?

Angel R. Martinez

We really don't see a significant cannibalization risk. We feel that the product that we're currently selling, what people know as UGG classic and what people know as extension to the classic line and those price points, that is all very stable, very solid. The new product that we're talking about allows us to compete where we got pushed out of those segments of the market. In some cases, we really were never effectively able to go into the market with any consistency because of the last few years, the increase of the sheepskin pricing. Young consumers and I'm talking about teen consumers, for who $200 is a lot of money. Just a few years ago, classic was available at $120. So really what this does, it allows us to gain traction, once again, in that target core customer that just had to move past UGG and move to maybe a knockoff brand or just out of the category or put off the purchase for a year or 2, just because the product got pretty expensive. The other thing I'd add is there's a lot of consumers out there. We call them prospect consumers. It represents about 23% or 24% of consumers who, among the reasons they didn't purchase UGG was, it was just a little bit -- it was just too expensive. So our goal is to bring new consumers into the mix with new categories, new products, to really broaden the opportunity for the brand.

Camilo R. Lyon - Canaccord Genuity, Research Division

Got it. And maybe if you could just amplify a little bit more, what will be different from a consumers' perspective other than price point between the Pure product and the classic UGG boots.

Angel R. Martinez

The differences are pretty significant because they are -- we're able to engineer the product to precisely the spec we want. So to give you an example, at the current level of classic product, we're known for the density of the material. The wool inside is quite dense. It lasts a long time. It's very thick and plush. And that will continue. One of the problems with making product that is thinner in the sense that it's a lighter way for, say, warmer weather, is that when you shave the wool down, it loses its durability. It compacts over time, and this new technology allows us to engineer density and not have to have the thickness, which allows us to make -- diversify the number of styles we can make. We can make styles that are closer to the foot. We can also engineer different densities of material for different seasons, different weights, et cetera. So all of this was a very big limitation when you're just dealing with conventional sheepskin, which comes only one way, and you're very limited in what you can do to create differentiation. So we're going to be able to, now, differentiate the product line much more completely than we ever had in the past.

Camilo R. Lyon - Canaccord Genuity, Research Division

Have you tested this product in-store to see the receptivity or the differences between purchase behavior around the classics versus the Pure?

Angel R. Martinez

We have tested it extensively with consumers. And as I said, it is preferred, actually, and when it's a blind test, we think that the consistency of the material -- by the way, twin face sheepskin is not a very consistent material. It actually -- there's a tremendous amount of variation from both regions of the world where the hive come from and the seasons in which -- the winter that the animal has lived through. So that's been an issue and it's a natural product. So it's created a lot of this type of a challenge for our product development teams, and I think we may be able, now, to overcome a lot of that.

Operator

.

And our final question comes from Chris Svezia with Susquehanna Financial Group.

Christopher Svezia - Susquehanna Financial Group, LLLP, Research Division

So I guess my first question, just going back on the inventory piece. Tom, for you, I mean if you're down slightly or flattish in the second quarter, how do we think about the inventory growth progression in the back half of the year? Does it run roughly in line with sales or how do we think about that?

Thomas A. George

I think that -- what I'd like to comment on there is, I think, by the third quarter, it's a big quarter, we're going to need the inventory to support that and I think I'd like to push it to the fourth quarter. I think we're comfortable that by the end of the year, we expect the inventory levels to be down relative to where they were a year ago. So at the end of December 2013, that inventory you'll be looking at will be down relative to what the inventory was at the end of December 2012.

Christopher Svezia - Susquehanna Financial Group, LLLP, Research Division

Okay. All right. And then Angel, for you, when you talk about UGG Pure -- 10%, I guess, is the lining and ultimately give me the 25%, any time frames around that, this year, next year, I'm just kind of curious when you hit those targets?

Angel R. Martinez

We're moving as aggressively as we can. Again, we're building a supply chain around this material from scratch. I don't want to overstress the supply chain and create serious problems on our end. So we're going to be -- we're moving very aggressively. I would say 2 to 3 years would be a reasonable window in which to expect that 25% number. But if we can move faster, we will.

Christopher Svezia - Susquehanna Financial Group, LLLP, Research Division

Okay. All right. And then, Angel, in the past, I think, in the last call, you made some comment about how you're looking at distribution in the U.S. and those retailers that either or not showing a brand in its entirety, et cetera, just focusing much on the classics. I mean, how -- where do we stand, right now, on that thought process, in terms of maybe some consolidation at U.S. wholesale for the UGG brand?

Angel R. Martinez

That's an ongoing conversation. It's a season-to-season conversation. We're pretty happy with our stable of retailers, I'd say. The vast majority value of the UGG brand for them, it's sort of an irreplaceable part of their revenue and profit picture on a year-round basis. So it's a very, very important brand for them. We don't see that many violators out there of our [indiscernible] policy. And when we do, we take appropriate action. Retailers have been very cooperative in offering the spread and assortment of product that we've asked them to, given that, in fact, some retailers just don't have the room, they don't have the type of store that is appropriate for all of our -- we understand that. So we're very flexible in working with people. And I'd say that, so far, the response has been extremely positive. Yet, there are still fringe players out there who are opportunistic and just want to use the brand as a loss leader or in some cases as a way of messing up a market, I suppose. Some people will constantly try to get the brand so that they can just claim they have UGG and they will not be undersold and violate everyone's -- sort of the integrity of our distribution. We're a lot more aggressive, and we come down on that behavior quite hard. So we'll continue to do that. It's an ongoing management year-round and it's also the distribution management globally now as well. It's not just the U.S., it's all over the world.

Christopher Svezia - Susquehanna Financial Group, LLLP, Research Division

Right. Okay. And then last question I have is just on this, I just want understand something on the cancellation rate. If this time last year I don't think you anticipated what would happen in Q3 and I'm sure that's where you saw the majority of your cancellations occur. I mean if we come through third quarter and you obviously don't see that level of cancellations, I mean, how do we think about the revenue thought process there if that's doesn't materialize? I'm just trying to understand that for a second, in terms of how you're thinking about that cancellation rate being same year-over-year.

Thomas A. George

Yes, I think another thing to point out, Chris, is, last year, not only do we have a fair amount of cancellations in the third quarter, we had a fair amount in the fourth quarter too, when the weather got sort of inconsistent. So let's keep that in mind from your thinking perspective. And if everything else being equal, we have less cancellations and we've assumed in our guidance, everything else being equal, that we should have some upside in our wholesale number.

Operator

And that does conclude the question-and-answer session. I will now turn the conference back over to you for any additional or closing remarks.

Angel R. Martinez

Well, thank you all for joining us on the call, and I think we have made significant progress in this year. We'll continue to drive the opportunities that we feel we have for this company across all of our brands, and we look forward to the next call.

Operator

And that does conclude today's conference. We do thank you for your participation today.

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