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Saks Incorporated (NYSE:SKS)

Q1 2013 Earnings Call

May 21, 2013 9:30 am ET

Executives

Stephen I. Sadove - Executive Chairman and Chief Executive Officer

Kevin G. Wills - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Ronald L. Frasch - President and Chief Merchandising Officer

Analysts

Deborah L. Weinswig - Citigroup Inc, Research Division

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Paul Trussell - Deutsche Bank AG, Research Division

Paul Swinand - Morningstar Inc., Research Division

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

Steven J. Kernkraut - Berman Capital Management LP

Kimberly C. Greenberger - Morgan Stanley, Research Division

Robert S. Drbul - Barclays Capital, Research Division

Barbara Wyckoff - CLSA Asia-Pacific Markets, Research Division

Rick L. Snyder - Maxim Group LLC, Research Division

Michael B. Exstein - Crédit Suisse AG, Research Division

Dana Lauren Telsey - Telsey Advisory Group LLC

Operator

Greetings and welcome to the Saks Incorporated First Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Steve Sadove, Chairman and CEO of Saks Incorporated. Thank you, sir. You may begin.

Stephen I. Sadove

Thanks, Christine. Good morning. This is Steve Sadove, Chairman and CEO of Saks. I'm joined on the call today by Ron Frasch, our President and Chief Merchandising Officer; Kevin Wills, our CFO; and Julia Bentley, our Senior VP of Investor Relations. I'd like to thank each of you for taking the time to join us.

First, let me note that some of the comments on the call today, as well as some of the information presented in our release related to future results or expectations are considered forward-looking information within the definition of the federal securities laws. The forward-looking information is premised on many factors, and actual consolidated results might differ materially from projected information if there are any material changes in our assumptions or in the various risks related to our industry and our company. For a description of the risks and assumptions related to these projections, please refer to the release and our filings with the SEC, including our most recent Form 10-K.

Also, let me remind you that the fiscal year ended February 2, 2013, included an extra week, creating a 53-week fiscal year that occurs every 6 years in the accounting cycle for many retailers versus a 52-week fiscal year in other years. This 53rd week and later fiscal year end has pushed each of the quarter ends in 2013 later than in the prior year and is distorting certain comparisons. So on the call today, we'll adjust for this distortion in certain instances comparing the 13 weeks ended May 4, 2013, with the 13 weeks ended May 5, 2012, and likely know what more apples-to-apples comparisons would have been. Today, we'll discuss financial results for the first quarter ended May 4, 2013, our outlook for the balance of the year, and give you a general business update. At the end of the call, we'll be glad to respond to your questions.

Before I turn the call over to Kevin to discuss the financial results, let me make a couple of comments. I'm pleased with our first quarter comp store sales growth of 5.9%, which was on top of a 4.8% increase in last year's first quarter. Adjusting for the distortion caused by last year's 53rd week, first quarter comp store sales would have been approximately 4.2%, which is still a solid performance. Trends improved throughout the quarter as the weather got better, and it appears that concerns over the fiscal cliff and increased tax rates subsided somewhat. I'm also pleased that we maintained a 44.4% gross margin rate, which was flat with last year even in an increasingly promotional environment. As expected, we experienced SG&A deleverage during the quarter. 2013 is another important transformational year for Saks as we continue our omni-channel evolution. As we've discussed, we're making strategic long-term investment in infrastructure and technology, what we're calling Project Evolution, that will enable us to further enhance our omni-channel capabilities. These investments will continue to take place in the near term and put pressure on our near-term profitability. However, we're taking the right actions and a long-term approach to the business. We're positioning our company for future revenue and earnings growth.

We've increased our anticipated 2013 SG&A expenses above our original expectations, primarily due to 2 factors: First, we expect to incur approximately $5 million to $6 million of additional expenses related to Project Evolution, which is key to our omni-channel transformation. It can be difficult to project all expenses associated with a multi-year project of this magnitude. As we've gotten further along in the process, we generally remain on schedule but expect to incur more expenses in '13 than we initially anticipated. Our expected total capital investment in the project remains unchanged at approximately $85 million to $90 million. We remain absolutely confident that this investment is the right one for the business.

Second, we've accelerated the planned launch of OFF5TH.com into the fall of 2013 from 2014 previously. And we'll incur approximately $5 million to $6 million of start-up and incremental operating expenses associated with this project. I'll talk more about OFF5TH.com and our outlook for the balance of the year later on the call.

I'll now ask Kevin to make a few comments about the first quarter results and the balance sheet. Kevin?

Kevin G. Wills

Thanks, Steve, and good morning, everyone. For the current year first quarter, we posted net income of $20 million or $0.13 per diluted share. The results included after-tax items totaling $10.1 million related to store closing costs and a noncash loss on debt extinguishment related to our convertible note redemption, which I will discuss more in a moment. Excluding these items, we would have recorded net income of $30.1 million or $0.19 per share. This compares to last year's net income before certain items of $32.7 million or $0.19 per share.

For the current year first quarter, our 7.5% convertible notes were diluted, therefore, the applicable shares, approximately 16.5 million, were added to the weighted average shares outstanding and the applicable after-tax interest expense, approximately $1.7 million, was added to net income for the diluted earnings per share calculation.

Also, our 2% convertible debt was diluted until the March 15, 2013 announcement of the redemption of the notes for cash. Therefore, the applicable pro rata shares, approximately 8.7 million, were added to the weighted average shares outstanding and the applicable pro rata after-tax interest expense, approximately $0.7 million, was added to net income for the fully diluted earnings per share calculation. All the numbers we will discuss today, exclude the previously mentioned call-out items, detailed in today's release.

As Steve noted, we posted a 5.9% comparable store sales increase on top of a 4.8% comp increase in the first quarter last year. Several merchandise categories showed sales strength during the quarter, including women's contemporary and advanced designer apparel, dresses, women's shoes, handbags; children's apparel; and men's accessories, shoes and contemporary apparel.

The New York City flagship store sales increase was positive, but modestly below the comparable store sales increase of our Saks Fifth Avenue stores in the aggregate for the quarter. Sales trends in the flagship improved as the quarter progressed.

Our year-over-year gross margin rate was flat at 44.4%. As Steve commented, we were pleased with this performance in light of the overall promotional environment, which has ratcheted up over last year. Our year-over-year promotional activity was generally in line with the prior year, with the exception of our 5-day Friends & Family event held in April. The overall discount percent for Friends & Family was increased to 25% from 20% last year. We did continue to exclude a number of designers from that event, however, and in fact, the number of exclusions increased year-over-year.

As a percent of sales, excluding certain items, SG&A expenses were 26.7% in the first quarter this year compared to 25.2% in the prior year first quarter. As anticipated, we experienced deleverage in the quarter primarily related to incremental expenses to support our omni-channel and Project Evolution initiatives, as well as additional marketing expenses targeted to maximize omni-channel revenues.

In addition, with the outsized growth of saks.com and the growth of ship from store, we incurred increased fulfillment and shipping expenses. Let me remind you that a portion of the SG&A rate pressure arises from the outsized growth of saks.com. Saks.com has a higher SG&A but a lower depreciation and rent expense structure as compared to our traditional store base. The direct model by definition has a lower fixed asset investment, but a generally higher selling and marketing base due in part to free shipping, search engine expenses and site development and maintenance. We expect the penetration of saks.com to continue to increase over time, and this will create some natural headwinds in our ability to leverage SG&A.

We generated operating income again, excluding certain items, of 7.5% of sales in the current year first quarter compared to 8.7% in the prior year first quarter. Now let me turn to the balance sheet.

Consolidated inventories at quarter end totaled $856.4 million. This represents a 7.9% over the prior year from both a total and a comparable store basis. Quarter-end inventories were somewhat distorted due to the later fiscal quarter end this year of May 4 compared to April 28 last year with more receipts in the first week of May this year than in the last week of April last year. It is typical for merchandise receipts to be more concentrated early in the month and consequently, we may report higher levels of inventory at each quarter end as we go through 2013.

Adjusting for this distortion, our comparable store inventories would have increased by approximately 6% at quarter end. We generally remain comfortable with the level, content and currency of our inventory. We expect that our adjusted comp inventories will be in line with comparable store sales trends by the end of second quarter and throughout the balance of the year.

During the quarter, we made 2 important changes to our capital structure. First, we amended our existing revolving credit agreement, increasing the maximum availability from $500 million to $600 million, and extending the maturity date to March 2018 from March 2016 previously. The amendment also favorably revised certain terms of the existing revolving credit facility, including the interest rates and unused line fee. Secondly, we redeemed the entire balance of our $230 million outstanding principal amount of the 2% convertible senior notes due March 20, 2024, using a combination of cash on hand and availability under our revolving credit facility. No shares were issued in the settlement of the notes. The redemption eliminated any particular put risk because the notes were puttable back to us in March of 2014, and we eliminated any future potential share dilution.

I would also note that this future dilution risk was eliminated without a corresponding increase in interest cost as the current interest rate on the revolver approximates the interest rate on the redeemed convertible notes.

At the end of the first quarter, we had approximately $20 million cash on hand and $175 million of outstanding borrowing on our revolving credit facility. Our funded debt, including the balance of revolving credit facility, our capital leases, 2.1 million senior notes and the remaindering convertible debenture with a balance of $91.2 million, in May 4, 2013, totaled approximately $319.6 million and debt to capitalization was 21.5% without giving effect to cash on hand.

Actions we have taken in the last few years, including the ones we took this quarter, have continued to strengthen our balance sheet. We remain very comfortable with our capital structure, liquidity position and overall financial flexibility.

Finally, net capital spending for the first quarter totaled approximately $53.3 million.

Let me now ask Ron to update you on some of our initiatives.

Ronald L. Frasch

Thanks, Kevin. Allow me to give you an update on some of our merchandising, marketing, service and store initiatives. Last quarter, we talked about some important organizational changes in the merchandising and marketing areas that were made in order to facilitate our omni-channel approach to the business. These changes and the new organizational structure are working, and I'm pleased with how the team has embraced our omni-channel evolution. I can assure you that omni-channel is top of mind for our team and has become integral in how we strategize, manage and execute the business. A prime example is how differently and collaboratively our Saks Fifth Avenue full line and online merchandise and marketing teams are working with each other and with our vendors as an omni-channel retailer. We are really staying the course with our overall merchandising strategies, focusing on differentiation and building our powerful signature businesses like shoes, handbags, and women's and men's contemporary apparel, both online and in our stores. We remain committed to growing sales and expanding our gross margins over the long term through the execution of these strategies and believe there is meaningful opportunity for improvement especially as omni-channel continues to take hold.

On the marketing front, we continue to work in a number of important initiatives, but first let me briefly talk about our promotional calendar and activity in the first quarter. Overall, we made a few minor changes to our promotional calendar during the period, but generally stayed the course during what we saw as increasingly promotional environment. As Kevin mentioned, the only noteworthy change related to the increased discount percent on our Friends & Family event in April. Additionally for this event, we offered double points in our designer women's and men's apparel shoes and the handbag categories.

As you probably recall, we relaunched our SaksFirst loyalty program earlier this year in order to broaden our membership reach and add new benefits to drive greater customer engagement and spend. We removed the $1,000 threshold previously required to enroll in the program, expanding the program to all Saks cardholders. And in this spirit of omni-channel, we also extended the program to our OFF 5TH customers for the first time and added free ground shipping, both from in store and online to all SaksFirst members. We have been pleased with the response from both our customers and associates to our improved SaksFirst programs, and we experienced an increase in the use of our proprietary card during this quarter. We remain optimistic that this will continue to drive loyalty and sales over time.

Over the next year, we expect our marketing efforts to become even more strategic and targeted. We continue to leverage our customer analytics and are implementing several targeted marketing programs using our customer database as well as the databases of our external partners. Our digital marketing programs, which impact both in-store and online traffic, have evolved and indeed have come a long way, including the expansion of our reach through mobile and social media.

In the first quarter, we adapted all of our email, search and media advertising to be mobile friendly and we continue to test digital advertising in social media platforms such as Facebook. We have implemented a social media analytics tool to better understand and enhance our customers' social engagement. We have also continued to expand our digital marketing internationally. Local marketing is still a critical focus, with the stores responsible for their local marketing, business development and customer growth plans. Press and in-store events surrounding our key renovations continue to drive national and local buys, reinvigorating markets and providing a new reason for customers to visit Saks. For example, our first quarter Beverly Hills and Chevy Chase renovations created in-store excitement that resulted in a lift in new customers in these stores. And we continue to explore and embrace new and differentiated marketing concepts to broaden the reach of our brand. We have just wrapped up the second season of NBC's Fashion Star. Our participation in Fashion Star has driven incremental traffic to saks.com and has exposed new customers to Saks.

On the service front, our mission is to inspire customer confidence in style with every Saks shopping experience, no matter what channel they choose to shop. We're very focused on elevating our customer's in-store service experiences and over the last couple of years, our customer service scores have steadily improved. We want to build personal relationships, create excitement and fun, and provide special moments and memorable experiences to all of our customers, with particular emphasis on our top and high potential customers. Of course, we will continue to enhance our website shopping experience to improve conversion and drive sales in our stores. Our site routinely receives industry recognition and ranks among the very best in customer service.

Probably the most exciting development in the service area is how our associates are embracing omni-channel retailing and using technology to drive sales. By using iPads that link to saks.com and our internal look books, associates have at their fingertips a much broader assortment of inventory than what can be found in a typical Saks Fifth Avenue store. We are spending time and resources improving our clienteling and other systems on training associates to effectively use the technology and on sharing best practices. With sales associates embracing omni-channel, this drives not only sales but nurtures lifelong relationships with our customers, which is a huge opportunity for us.

Now turning to the stores. Our focus over the last few years has been to improve the productivity of our best stores through targeted capital investments and to exit underperforming locations as promptly and economically as possible. We have made meaningful progress on all fronts, and the overall health and quality of our real estate portfolio is significantly improved.

Since the beginning of 2010, we have closed 11 stores and have announced the planned closings of 2 more, Dallas in June and Stanford early next year. These closings allow us to simplify the business, reduce working capital and capital spending requirements, and then more effectively focus our resources. Going forward, we will continue to focus on maximizing the productivity of our most productive stores to increase market share and to look for additional opportunities to rationalize our store base where it makes sense.

We have had and continue to have several exciting store renovation projects in the works. During the first quarter, we unveiled our Beverly Hills men's renovation, which includes a really unique men's club concept with the largest men's shoe offering in the West Coast, an impressive denim bar, several new and renovated vendor shops, a pool table and other fun amenities. Our customer and vendor response has been very positive.

In addition, we are relocating our Chicago men's store, which is a separate store located across the street from our main store into our main store. This space will occupy the sixth and seventh floors of the store, and the space and merchandise assortments will set us apart in that important market. The Chicago renovation should be completed in the fourth quarter of this year. We are also renovating the men's area in Boca Raton, remodeling the women's designer floors in Boston and Atlanta and finishing up renovations in Chevy Chase, Bal Harbour and Troy. By the end of the year, we will have completed the addition and renovation of over 100 vendor shops and other stores across the country. Many of our renovations and the new vendor shops will continue to focus on our main floor signature businesses of shoes, handbags and accessories. We will relocate our Sarasota store and expand our presence in that important market there by opening an 80,000-square foot store in the University Town Center in 2014. We are also on track to open a store in San Juan in 2015.

On another note, we are excited that John Cruz has returned in New York to manage our flagship store. John has been with Saks for nearly 20 years and most recently served as the general manager of our second largest store in Beverly Hills. He previously held positions of increasing responsibility in the New York Store for nearly 7 years and prior to that, held key posts in Chicago and Chevy Chase. His strategic ability and keen focus on both our customers and our associates make him an ideal leader of our most important location. Steve?

Stephen I. Sadove

Thanks, Ron. Let me now turn to OFF 5TH, where we will continue to focus on growth through our real estate expansion and renovation strategies. We continue to be presented with many attractive opportunities for new OFF 5TH stores throughout the country, but we remain very selective in our expansion process. We've also widened our reach to locations outside of conventional outlet malls into neighborhood center locations. We have plans to add 7 new stores and 1 replacement store, and to renovate 4 others in 2013. Currently, 30 of our 66 stores are designed in our luxury-in-a-loft format, and all of the new and renovated stores will be, too.

In the aggregate, our new and newly renovated stores continue to outperform the remainder of the OFF 5TH store base. Probably the most exciting news at OFF 5TH is our development of OFF5TH.com, which as I mentioned previously should launch later this year. As the e-commerce business has evolved, it is clear that an omni-channel opportunity exists for us in the off-price channel. We've accelerated our efforts in this area and believe that this will position us to extend our reach to more customers and to sell more to existing customers.

Let me turn to our OFF5TH.com in terms of -- we expect that we -- we expect that our .com business will continue to grow especially as we further embrace omni-channel. Over the last several years, we've invested a substantial amount of resources in the saks.com organization, infrastructure, site design and site content. These investments are ongoing and should continue to generate dividends. During the first quarter, we launched our redesigned saks.com site to include a longer, more fluid layout that more prominently highlights seasonal trends and most wanted designers. New features include large-scale photography, improved navigation, magazine-style features with increased exposure and easier access and improved product detail pages. We continue to receive accolades about the site and our social media efforts, including being named Best Website and Best Blog in the 4th Annual Fashion 2.0 Awards in March.

Of course, our most critical and exciting initiative is our omni-channel transformation. We've made a lot of progress to date with Project Evolution, our multi-year systems conversion, which will deliver new merchandising, finance and human resource systems and capabilities on an integrated application suite for the entire business. Project Evolution will facilitate any channel anytime shopping. We're implementing the systems conversions in a very methodical phased approach through 2016. We're operational with buy online ship from store, which enables us to fulfill online orders for items sold out online but in stock in our stores. We've been very pleased with our results to date and are learning what works and what doesn't. As we continue to learn and adjust our systems, we expect the benefits of buy online, ship from store to increase as we move throughout the year.

Last fall, we also began putting select store only styles on saks.com to increase assortment selection online and to increase sell-throughs of existing products. Due to our initial success with this initiative, we're in the process of expanding our photo studio and other support capabilities so that we can increase the number of items that we're putting online. These inventory sharing initiatives may also allow us to increase inventory assortments in key stores, where we have targeted specific merchandise category growth opportunities. We'll be able to show a greater assortment of products on the floor, but at the same time mitigate the sell-through and markdown risk of building these emerging businesses. These changes should result in higher inventory productivity and efficiency, as well as improved reporting and analytics over time.

Since Project Evolution is a multi-year project, the full benefits from these investments will not be realized right away. Our conversion to an omni-channel retailing is what I call a crawl, walk, run process. We began crawling in 2012 and we're now starting to walk. We still have a ways to go before we're running, but the future prospects are very exciting.

In this morning's release, we outlined our assumptions for the balance of 2013. Please keep in mind that variation from the sales trends up or down could materially impact our other assumptions. Let me go over a few of the highlights.

Comp store sales are expected to grow in the 4% to 6% range for the balance of the year, with modestly higher growth in the second half of the fiscal year than in the second quarter. Comp store inventory levels are expected to be up in the 4% to 5% range through the balance of the year. Based upon current inventory levels and composition of our promotional calendar and permanent markdown cadence, we expect our year-over-year gross margin rate to be relatively flat for the balance of the year. As a percent of sales on a year-on-year basis, we expect approximately 90 to 100 basis points of SG&A expense deleverage in the second quarter and approximately 50 to 60 basis points of deleverage in the third quarter. For the fourth quarter, we expect SG&A expense to be relatively flat, bringing the SG&A deleverage for the full year to approximately 70 to 80 basis points. Keep in mind that year-over-year comparisons of the 2013 SG&A expense rate for the fourth quarter and fiscal year are being negatively impacted by the 14-week fourth quarter and the 53-week fiscal year in 2012, which modestly enhanced the prior year expense leverage.

For the year, SG&A dollar increases primarily are expected to rise from incremental variable costs associated with planned sales growth, primarily sales associate commissions, investment spending to support our omni-channel initiatives, incremental spending on Project Evolution and the planned launch of OFF5TH.com, both of which I mentioned previously and targeted incremental marketing spending. All of the required omni-channel, Project Evolution and other investment spending that we have discussed will limit SG&A leverage in the short term. However, we're confident that this is the right long-term strategy for the company and will enable us to improve the customer experience and optimize the efficiency of our inventory investment.

We expect other operating expenses, rent, depreciation and taxes other than income taxes to total approximately $82 million for the second quarter of 2013 and approximately $170 million to $173 million for the second half of 2013, bringing the total for the full fiscal year to approximately $333 million to $336 million. The increase over the prior year is being driven primarily by higher depreciation on incremental capital spending; increased rent expense related to Project Evolution and new OFF 5TH stores; and higher taxes other than income taxes, primarily payroll, sales and use taxes and property taxes. Approximately $5 million of the year-over-year increase relates to Project Evolution.

We expect net capital expenditures of approximately $145 million to $155 million for the year. Approximately $75 million relates to Saks Fifth Avenue store renovations, new vendor shops and the purchase of 2 service parking lots used by the Beverly Hills store. Approximately $55 million relates to Project Evolution and other information technology enhancements. And the balance relates primarily to OFF 5TH and maintenance capital. The increased level of capital investment reflects our confidence in the business and the belief in the potential return on investments of these opportunities.

What I'd like to do is open it up in a moment to questions. I'd just like to make a comment that extraordinary changes are going on in the retail industry, and I'm excited about the changes and what they mean for our business. I believe we're taking the right necessary steps to transform Saks into an omni-channel retailer and to assure that we achieve our long-term goals.

At this time, I'd like to open it up to questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Deborah Weinswig with Citigroup.

Deborah L. Weinswig - Citigroup Inc, Research Division

Steve, can you talk about some of the details regarding the building strength of the flagship during the quarter?

Stephen I. Sadove

Yes, I think that what you have in New York is -- the trends improved in New York but there's still -- and they're positive, but it's still, a little bit weaker than I would have liked to have seen. It's not quite as strong as I'm seeing overall in the total store base. It's being dragged down a little bit by the international trends. We can talk later in the Q&A on international but total international is growing about in line with what we're seeing in our store base. But international in New York is a little bit weaker primarily because the European tourism is down a bit. You're still seeing growth in the Chinese tourism, the Russian, the Middle Eastern business is actually growing right now. So overall, I feel like the -- if I look at it on a month-by-month basis, you saw improvement over the course of the quarter. Probably some of the concerns over the taxation fiscal cliff may be being alleviated a little bit. And I saw resurgence back in some of the fine jewelry sales in New York. But overall, I still don't feel it's quite as robust as I was seeing earlier, let's say, a couple of years ago.

Deborah L. Weinswig - Citigroup Inc, Research Division

Okay. And then, you're really the first retailer who's moved to an omni-channel management team. Can you talk about the impact that, that's having on your business? I know it's still early.

Stephen I. Sadove

Well, I think it's early. I thought Ron expressed it well. You have an enormous amount of enthusiasm on the part of the team. There's a lot of learning going back and forth between the organization in terms of best practices of going to market together. There's a lot of cooperation. But we -- as I use that word crawl, walk, run, we're just in that early stages of that as well and whether it's best practices of buying from one channel to another or how do we best utilize the inventory and the ship from store, we're just learning in that. So I feel really encouraged. I don't know, Ron, if you want to make a comment on it?

Ronald L. Frasch

No, I agree, Steve. It's -- we're only a few months into this, Deb, and the initial reaction at the buyer and planner level has been an embrace of omni-channel as a concept. We're going through initial strategy sessions for 2014. And the ideas that are being developed by the guys in terms of inventory efficiencies, better ways to market and strategize key brands is very exciting. And so we have a lot of intellectual power in the organization and it's great to see it unleashed, and it's completely embraced.

Deborah L. Weinswig - Citigroup Inc, Research Division

Okay. And then lastly, as we look at your growth in terms of OFF 5TH, Steve, can you talk about the neighborhood center locations if you have any now and how we should think about that in terms of just the growth and what that means for your bottom line?

Stephen I. Sadove

Well, I think what it does for you, and we have several of these here in the New York area, you'd see one in Westbury, Long Island, it was a replacement store for a store that we had, and we're in a neighborhood center. You have a Nordstrom Rack, a Container Store, Trader Joe's, a Bloomingdale's outlet and Saks. And the store is doing exceptionally well, we have one just north of Chicago as well that's performing well. So I think what it offers the opportunity for is another venue for growth. I think that it sometimes has -- the deal economics are a little bit different than the traditional outlet centers. They tend to be very high -- higher volume opportunities for the stores. But if you look at the neighborhood center, the traditional outlet mall and now the opportunity that I see for OFF5TH.com, the convergence of all 3 of them represents a substantial opportunity for OFF 5TH.

Operator

Our next question comes from the line of Lorraine Hutchinson with Bank of America.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

One longer-term question. Steve, you talked a lot about the transformative changes in retail. As you look forward a few years, what does the margin structure look like for Saks once some of these initiatives are rolled out?

Stephen I. Sadove

I think that, and if I look at it from an operating margin perspective, we've talked in the last several years about targeting towards an 8% operating margin. And I think that, that's still in the cards. And the -- we used the word moderate term, I'm not going to define exactly what the time frame is, but there are so many pieces there going on. Clearly, you've got SG&A pressure right now. I think you're peaking on some of the investment dollars, whether it's the CapEx dollars, that are going against the omni-channel, some of the expense dollars that we're putting in right now. We consciously made an effort -- a decision to invest and move along some of the major initiatives that we think will drive it for the longer term. I think that as you go out over time, those SG&A expenses will come down, especially on Project Evolution. We ought to be able to, with a decent comp, leverage the SG&A. And I think that you have gross margin rate opportunities over time, especially as we're in this omni-channel environment. That's what all of these investments are going to allow us to do. We're already seeing -- we started a little bit earlier than we thought we would on the ship from store. We didn't think we would be doing it until the latter part of this year. We started in November of last year, and we're finding the response exceptionally good. And in fact, we're having to really measure -- we have to really be careful in terms of how much we are shipping in it because we've got to maintain service levels at a very -- at a high level, and what we're finding is that it's a much better utilization of inventory. So if I look at it over time, you're going to have a more efficient use of inventory. I think it's going to offer gross margin rate opportunities. So all of that together, if we continue to manage the SG&A once we get over this hump, you have a better gross margin rate through better utilization. The inventory, I think you're going to be able to see it better in terms of operating margin.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Great. And then what was the reason for taking the gross margin guidance down for this year?

Stephen I. Sadove

I think we came down a little bit -- I do think that you're in a bit more of a promotional environment than we've seen in the past. Some of our -- and I'm not going to point to any one competitor. I think that it's across the board, a little bit more competitive in the environment, so you're seeing some of that. Our -- using the example of what we did in the spring on our Friends & Family, we went from a 20% to a 25%. There were clearly a lot more exclusions, but it was a bit more promotional. And so I do think that some of the change that we made in terms of going towards a flat margin was reflective of what we see as being a little bit more of a promotional environment.

Operator

Our next question comes from the line of Paul Trussel with Deutsche Bank.

Paul Trussell - Deutsche Bank AG, Research Division

Just a first follow-up on comments you made earlier about SG&A thinking about this longer term. Are you comfortable now that you're further along in Project Evolution to kind of say that post the fourth quarter of this year, you'll begin to produce SG&A leverage, given you'll be...

Stephen I. Sadove

Sorry, I don't want to give guidance. I think it's a little bit early to give guidance for '14. I do feel comfortable in telling you that SG&A, as it relates to Project Evolution, will come down. There's no question that we're in the peak year right now relative to the Project Evolution. I don't want to comment on the full P&L for '14, but I think that you can feel comfortable on the omni-channel Project Evolution part of it especially on the technology that on the expense side, but we're at the peak year right now.

Paul Trussell - Deutsche Bank AG, Research Division

Now turning back to the comps, could you just give a little bit more color about traffic versus ticket, and also how much progress you believe you're making with the new loyalty program especially for more kind of the entry price point shoppers?

Stephen I. Sadove

Yes, I'll answer the latter one first. I was really pleased in the first quarter on the loyalty program initiative. We saw a very good bump in the, what I'd call the premier elite, the entry-level loyalty customer. It showed in an increase in penetration in the card. And so it's gotten off to a very good start. Obviously, we're in the earliest stages right now, but I couldn't have been more pleased with what we saw in terms of the response to the loyalty program changes. So that was really on track to where we wanted it to be. As it relates to traffic, I would say traffic in the stores was -- we don't measure all of the stores. I think it was flattish, maybe down a little bit in terms of overall store traffic. I think that if you look at overall transactions and ticket, what you find is because we're now looking at this on an omni-channel basis between full line and direct and on a omni basis, both units and AUR ticket were up on the quarter. So we had positive trends overall. But clearly, you saw a little bit of shifting going on between stores to the Internet. We're not going to report Internet sales, but they were quite strong during the quarter. So there's a little bit of play going on there. But overall, if you were to look at it on an omni, it would show that our units as well as dollar ticket would be up.

Operator

Our next question comes from the line of Paul Swinand with Morningstar.

Paul Swinand - Morningstar Inc., Research Division

I just wanted to sort of -- digging deep on omni-channel, just trying to understand some more there. Just following up on Lorraine's questions, how do you think about the ROIC given the growing mix of omni-channel? I know you mentioned inventory efficiency, how much does that play a role, and do you have a target there as far as turns?

Kevin G. Wills

Well, Paul, I think we look at the business on a combined business. As Steve has indicated, there's tremendous structural change going on in the business today. So we're sharing inventory. We're using iPads in the stores. So it's very difficult to just break apart and try to look at a direct business. So we're looking at the businesses combined because we are complementary off of each other. And over time, our expectation is our ROIC will increase as we continue to get better in delivering the omni-channel experience, and that's what the Project Evolution is about. Ron talked about the organizational changes. All of that is designed to drive increased sales and inventory productivity over time.

Paul Swinand - Morningstar Inc., Research Division

Do you have a target for the chain-wide combined for the inventory efficiency or?

Kevin G. Wills

We've not given a specific target. What we have said that we would expect over time that we should be able to turn our inventory faster and increase our inventory productivity as we will now move -- be moving into an environment, where there is more sharing of inventory. But until we get further along in the process, we've not given specific guidance of our turn targets.

Paul Swinand - Morningstar Inc., Research Division

Okay, fine. Also just asking -- you talked about the tourism business a little bit. Is the omni-channel benefiting tourist sales sort of equally, or is that something that you'll sort of catch up on later?

Stephen I. Sadove

I mean, we were -- when I'm looking at the tourism business, we tend to look at it on the tourism affecting the stores and we're tracking it through our credit card sales. Now we do have a nice international business online that is growing quite rapidly. So separately from -- separate from the tourism business, we have a very good, robust international shipping Internet business. That tends to be people in country as opposed to people who have -- who are visiting the U.S. When we think about the store volume, we're more thinking about the tourists that are in the country. But we clearly look at growth of international on an omni basis, different components of it because of the international shipping is an important part of our strategy.

Paul Swinand - Morningstar Inc., Research Division

And then finally, just sort of on the same lines, as you mentioned that Internet is growing stronger than the stores. Is that shifting your demographics a little bit, a little more younger, a little different geography, or anything like that?

Stephen I. Sadove

Not shifting geography much, it's shifting the consumer base a bit. If I look at our Internet customers, it's a bit younger than the store customer base, but we're also growing an omni-channel customer that's shopping across channels. But if you were to just look at the Internet purchases versus the store purchases, you would find that we're building a younger customer base.

Operator

Our next question comes from the line of Jennifer Davis with Lazard Capital Markets.

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

My question is on gross margins. In the first quarter, I mean how should we kind of think about it, and I'm sorry, if I missed this if you already talked about it a little bit, in terms of -- should we think merchandise margins down a little, partially offset or offset by leverage on the comp? And then going forward, should we think about with -- regarding the flat gross margins I think you had said, some increased promotional activity in the competitive environment. Previously, you had guided to 20 to 40 basis points of improvement. So I guess my question is kind of around the competitive environment, especially as we go into the sales periods of the second and the fourth quarter, what -- how do you view inventories and how do you view that going forward? And then, are you seeing any benefit yet from the increased full-price selling from buying online and shipping from the store, or is it still too small of a piece?

Stephen I. Sadove

Well, I talked a little bit earlier. I think you are seeing a little bit more -- or I think the decrease, if we want to call it, from the previous guidance on the gross margin rate does reflect a little bit more competitive environment that we're in. We increased our Friends & Family from 20% to 25%, as I had said, and we took in -- we brought in a few more exclusions though. I think that you're -- it's more about the promotional environment that leads you to the flattish gross margin more than anything else. It's not on leverage of expenses. We're feeling very encouraged on the ship from store -- the Internet linking omni, the ship from store initiative. But you're still in the early very early stages, I called it crawl, walk run. And the percentages that we're dealing with are still relatively small. It's bigger than we had anticipated, and we're feeling very good about the impact on driving full-price selling. But it's in the very early stages because we're still in the piloting and managing to make sure that we -- one of biggest issues you have to deal with here is one is the photo capacity to be able to put them up online and be able to merchandise the site with all the product moving it around, but the other is we've got to make sure that we continue to give a very high service level. Our fill rates of the product when you're shipping it from the store have to be on a level of an experience that's comparable to what you get out of the -- when you order it online from the Internet. And we've got to make sure that we don't sacrifice service and alienate the customer experience, and that's part of the reason that we're walking before we run.

Operator

Our next question comes from the line of Steve Kernkraut with Berman Capital.

Steven J. Kernkraut - Berman Capital Management LP

I know you've been talking about this crawl, walk, run. I just wanted to probe a little bit more into your inventory question, where inventories are up 8% now and I guess when you adjust it, it's 6%. But given that you have this whole omni-channel strategy, your inventory is going to become much more productive when you will have ship from store and all these other elements, and you'd be able to maximize margins. When should we start seeing the inventory levels increase at a slower rate than sales? Is that something that we should see in the end of '13, or is that a '14, '15 type of strategy?

Stephen I. Sadove

I think you should start to see that as we go into '14. I don't think you'll see that this year. I mean, we have said that we'll probably be about in line -- inventories about in line with comp for the remainder of this year. I think as you start to become more efficient on that inventory and we're much broader on it, that you ought to see going into next year.

Steven J. Kernkraut - Berman Capital Management LP

Okay. And with the launch of OFF5TH.com, is there going to be a ramp-up of inventory there as well, so there's going to be a blip up towards the tail end of this year?

Stephen I. Sadove

There might be a tiny bit. I don't think it's going to be a material number, but clearly we're just getting started on this one. We're obviously, in a very heavy investment mode for it right now to ramp it up, but it's going to be a relatively small number as you go towards the end of this year. But having said that, we think it's a very substantial opportunity for the OFF 5TH business over time. You'll see more of that hitting up in '14 than you would see in '13.

Operator

Our next question comes from the line of Kimberly Greenberger with Morgan Stanley.

Kimberly C. Greenberger - Morgan Stanley, Research Division

Steve, I'm wondering if you can talk about the overall health of the high-end consumer? And earlier in Q1, you talked about a slowdown in your high-end jewelry business. Any comments there would be helpful.

Stephen I. Sadove

Yes. I think that the high-end consumer is doing okay. I still use the word there's a little bit of crosscurrents going on. The Dow is in the 15-2 range, and you'd say, wow, that's a remarkable improvement from where you were several years ago. On the other hand, you do have the things like the higher tax rates. We estimate that our core customer is probably seeing an 8- to 10-point increase in their tax rate, and that's affecting their behavior a little bit. So you're in a mode where the sector is doing okay, but I think it's not as robust as you might expect to see at that kind of a Dow. On the other hand, you're starting to see a return to some of the higher-end jewelry sales. We did see a slowdown during the end of last calendar year, beginning of this calendar year, and I think you're starting to see the consumer spending again. If I were to look at our most recent periods, you're seeing some -- an improvement in trends just as you have seen the New York Store improve in trends. You've been seeing some improvement in trend on some of the large jewelry purchases as well. I don't know, Ron, you want to make any comments?

Ronald L. Frasch

Yes. I think the season has improved as we've gotten further into it. But I mean, clearly the consumer is much more informed, is much more particular about what he or she is buying, and that makes us better retailers quite frankly.

Kimberly C. Greenberger - Morgan Stanley, Research Division

Maybe just one follow-up question. I know that the calendar shift this year distorted the first quarter comp because it's 2 periods that are not totally comparable. As you look out into the fourth quarter, which 13-week period will you be comparing Q4 against this year?

Kevin G. Wills

In the fourth quarter, we will be similar to what we've done now. We will give you the actual fiscal reporting comp, but we'll also give you the adjusted calendar comps.

Kimberly C. Greenberger - Morgan Stanley, Research Division

Okay. And then the guidance for the full year based on that fiscal comp that you'll be reporting, or the adjusted comp?

Kevin G. Wills

It's the fiscal comp.

Stephen I. Sadove

Yes, on an annual basis -- just on an annual -- just a follow-up on that. On an annual basis, I don't think it's going to be materially different between the fiscal and the calendar. Maybe what we're trying to do is on a -- within a quarter, it changes a little bit, but on an annual basis, we don't anticipate that it's going to be a substantial difference. Where you do see some differences and especially when you're dealing with a quarter end, it can be when we're flowing inventory, so sometimes you're going to see a difference in a comp inventory because of the flowing of goods at the beginning of a month. So that's going to affect it. That's why we want to give you a clear number in terms of what it is on a calendar-to-calendar basis. And you see a little bit of difference on a quarter.

Operator

Our next question comes from the line of Bob Drbul with Barclays.

Robert S. Drbul - Barclays Capital, Research Division

A couple of questions on the -- just on the sales. Did -- was the OFF 5TH business materially different from the reported comp?

Stephen I. Sadove

Bob, we're not reporting comps on individual pieces of the business. So obviously, we continue to feel good about the growth prospects for OFF 5TH with expanding the new stores, with the merchandise initiatives that we have, as well as the OFF5TH.com. But I can't break out the individual segments in terms of the pieces of the business.

Robert S. Drbul - Barclays Capital, Research Division

Okay, okay. And then on the OFF5TH.com launch, will the merchandising strategy be the same as in the stores? I mean, do you have the authority and the ability to use same vendors, most of the same vendors and the mix on sort of made for factory or made for OFF 5TH versus full offering [ph]?

Stephen I. Sadove

Yes, it will be very similar to what you see on the regular OFF 5TH stores. I think in the beginning, you're going to see a very limited -- we're editing a limited number of assortments. I'm not going to give you the number of SKUs, but we have -- we've selected how many SKUs we're going to start with. We'll gradually expand it as we get out in time. What we want to do is we're doing all of the work in terms of what the sites going to be looking like, getting it ready, so we can be -- so we can launch it in the fall. But I think over time, you should expect it to reflect fully the -- certainly the assortment that we have in our OFF 5TH stores, and that would be the mix that would have, let's call it, we're in 25% to 30% of our own brand and then much of it being the brands that are cutting product for us that represent the OFF 5TH matrix.

Robert S. Drbul - Barclays Capital, Research Division

Okay. And then, back on the sales line, Steve, are there -- was there any geographic callouts? You talked about New York, the flagship store, any other sort of geographic callouts that you would give us on the sales performance during the quarter?

Stephen I. Sadove

I don't have a lot of geographic -- the Florida market continues to be an outperforming market for us. Our flagship stores tended to perform a little bit better. But I don't think there were any major trends that you saw. I felt good about our performance in the West Coast stores.

Robert S. Drbul - Barclays Capital, Research Division

Okay. And a question for Kevin. With the move on the capital structure, is it now sort of where you want it? Are there still opportunities for you to improve it from where we are today? Are you comfortable with this current capital structure?

Kevin G. Wills

Well, as we commented earlier Bob, we're certainly very comfortable with our capital structure and liquidity position. But you've heard us comment over time that we view our capital structure on a leverage perspective, on an adjusted debt-to-EBITDA basis and on a net basis, we're probably still a little bit north of 3x. And over time, we've said that we would probably like to get that closer to 2.5x. One thing I would point out, and you're probably well aware, we still got about $90 million of the 7.5% converts. Those notes mature December 1 of this year. Currently they're very deep in the money. So while we have not -- don't know exactly what will happen, we are certainly assuming right now that those do convert towards the end of the year, so that would further decrease our leverage as we go through 2013.

Operator

Our next question comes from the line of Barbara Wyckoff with CLSA.

Barbara Wyckoff - CLSA Asia-Pacific Markets, Research Division

A couple of questions for Ron. Classic women's sportswear last few quarters hasn't performed well. Did this improve in 1Q? And then how do you see it going forward for the rest of the year? What is the market doing to improve the situation? And then I have another follow-up.

Ronald L. Frasch

Ron Frasch. I mean, clearly, this has been the area of our biggest challenge for all of our women's apparel. We've been working with the brands now for close to a year. Some quite frankly more successfully than others who adapt their product offerings to be a little -- a little more modern. The customer, as I mentioned earlier, is very discriminating, and she is moving to where the fashion is and clearly letting us and the brands know that she's not going to buy something if it's not to her liking. So I would say we're probably in the middle stage into this, much more work to be done. Some, as I mentioned, have been able to move much faster than others.

Barbara Wyckoff - CLSA Asia-Pacific Markets, Research Division

Okay, all right. And then online versus stores, the sort of SKUs count, I'm not looking for an actual number, but is it materially higher versus the store average?

Stephen I. Sadove

Well, online -- no, we're materially higher in the stores than we are online, hugely. I mean, the online, and that's part of the reason -- as you look over time at that omni is the opportunity to put a lot more of the breadth of what we offer onto the website and ship it from the store. Historically, we've been a very edited key item focus online and to be able to offer, let's call it, a substantial portion of the New York shoe floor or something like that becomes the opportunity. But over time, we're going to figure out what the consumer really wants and be able to -- it becomes a question of the variable cost putting it up online versus the incremental revenue that it's going to be able to generate.

Operator

Our next question comes from the line of Rick Snyder with Maxim Group.

Rick L. Snyder - Maxim Group LLC, Research Division

Is the increased investment in 2/'13, is that an increase in the overall investment or is that just moving that amount forward? And in the first quarter because of the calendar shift, did we exchange a markdown week for a full price week? And if so, when does that reverse and what was the effect on first quarter gross margin?

Stephen I. Sadove

I mean, I don't think that -- you were shifting a markdown for full price. I think that was an apples to apples if you look at the quarter. And as it relates to the expenses, I mean, the capital expense is going to be about the same on a longer-term basis. On the expense side of it, it's a little bit early to tell whether or not it's going to be -- stick to it or come out of the latter year. So much of it is fluid, and it's a bit -- even though $5 million, $6 million is a lot of money in the scheme of the overall expense of evolution and the trade-offs we're making over a 4-year time frame, I'm not so sure whether it's incremental or not because we're moving and phasing things a little bit differently to make sure that we get the benefit of the important stuff now. So it's hard to answer whether that's truly incremental or just phased. I think that will become more apparent over time.

Operator

[Operator Instructions] My next question comes from the line of Michael Exstein with Crédit Suisse.

Michael B. Exstein - Crédit Suisse AG, Research Division

First off, Steve and management team, I don't think I have ever seen Saks as sort of strategically focused as it is right now in multiple levels. It's amazing. Can you just talk about it a couple of quick things. Number one, I've been getting a couple of emails from you all for 10% off if I order online. So I'm just wondering where that fits in, in sort of the promotional cadence, number one. Number two, have you sort of figured out how your logistic system is going to look over the next 2 or 3 years as you go to this omni-channel positioning? And do you need more localized distribution or will the stores do that for you? And will packaways play any part in what you're going to do with OFF 5TH in terms of both the stores and now the e-commerce site?

Stephen I. Sadove

Let me take a couple of them. Let's see. In terms of the logistic systems, I think that what you'll find is that in theory, every store becomes a distribution center as we play fulfill from the store. And now it's not as efficient as a shipping point as a distribution center would be. So we're running out of capacity already in the distribution center that we just built in Tennessee. So we're probably going to be having to add another DC at some point in the relatively nearer term. And so I wouldn't be surprised if -- we have a distribution center in Aberdeen, Maryland. We have one in California, a small one. We'll probably -- we have the one in Tennessee, we'll probably be adding another one in the nearer term. And then, using the -- for the remainder of the logistics system, being the stores, which will be a -- which will be ship points. As it relates to the promotion email comment, by and large, the bulk of all of our promotions are common between the stores and online, I'd probably say at a 90% type of level. Occasionally, we'll run an event that's online only. Sometimes it might be because we're running presale in the stores and we're running it at a different time online. Sometimes it's because of the differences between the businesses or a competitive situation that we might run something a little bit differently. You're probably referring to a mystery money event that we ran. And it's not out of line. We ran one in the middle, I guess, from the 14th to the 18th of May. But by and large, I would say we're 90% in that range common. But you'll occasionally see an event that's different. Let me just -- in terms of your OFF5TH.com, I'm trying to understand -- I didn't understand what you were asking about on OFF 5TH.

Michael B. Exstein - Crédit Suisse AG, Research Division

In packaway inventories right now, I don't think you really do them and will you start doing them just as Nordstrom Rack has had to do with them.

Stephen I. Sadove

What's the packaway inventory? Which of the pack...

Michael B. Exstein - Crédit Suisse AG, Research Division

Will you buy -- packaway, you buy 6 months in advance and hold it for 6 months.

Stephen I. Sadove

I don't know. Honestly, I'm not sure. I mean, we certainly hold -- when we ship some of our inventory from our full line stores and sell off and -- before we send it to the OFF 5TH, sometimes we'll call it locker stock and store it in the distribution center for the following season. I don't know, Kevin?

Kevin G. Wills

Yes, Michael, we might do a little bit of that in OFF 5TH, but it's not very much.

Operator

Our next question comes from the line of Dana Telsey with Telsey Advisory group.

Dana Lauren Telsey - Telsey Advisory Group LLC

Can you talk a little bit about how the changes -- can you talk a little bit about how the changes in the loyalty program help the comp? And also, any more updates on the remodels of OFF 5TH and how those are progressing?

Stephen I. Sadove

I think I commented earlier, I really am very pleased with the changes in the loyalty program. You can see it in the penetration of the card, as well as in the sales among the lower tier of our loyalty customer, we call them premier and elite customers. I can't tell you translating in terms of how much that actually changed, x percentage point of the comp coming directly from that, but it clearly was a positive and directionally is where we wanted to head because it allows us to now do a lot more in the way of targeted marketing against that group. So we felt very good about how that was progressing. In terms of the remodels at OFF 5TH, we continue to see outperformance of the remodeled stores versus the legacy stores, as well as a stronger performance out of the renovated stores. So I think that that's all on track relative to the improved performance.

Operator

Mr. Sadove, we have no further questions at this time. I would now like to turn the floor back over to you for closing comments.

Stephen I. Sadove

Great. Thank you very much. I appreciate everybody being on the call. We really do appreciate your interest, and we look forward to talking to you next quarter. Thanks a lot.

Operator

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.

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