Aéropostale Management Discusses Q2 2013 Results - Earnings Call Transcript

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 |  About: Aeropostale, Inc. (ARO)
by: SA Transcripts

Aéropostale (NYSE:ARO)

Q2 2013 Earnings Call

August 22, 2013 4:15 pm ET

Executives

Kenneth Ohashi - Vice President of Investor and Media Relations

Thomas P. Johnson - Chief Executive Officer and Director

Emilia Fabricant - Executive Vice President of The Aeropostale Brand

Marc D. Miller - Chief Financial Officer and Executive Vice President

Analysts

Carla White

Paul Alexander - BofA Merrill Lynch, Research Division

Thomas A. Filandro - Susquehanna Financial Group, LLLP, Research Division

Betty Y. Chen - Wedbush Securities Inc., Research Division

Janet Kloppenburg

Randal J. Konik - Jefferies LLC, Research Division

Dorothy S. Lakner - Topeka Capital Markets Inc., Research Division

Edward J. Yruma - KeyBanc Capital Markets Inc., Research Division

Matthew McClintock - Barclays Capital, Research Division

Adrienne Tennant - Janney Montgomery Scott LLC, Research Division

Jay Sole - Morgan Stanley, Research Division

Anna A. Andreeva - Oppenheimer & Co. Inc., Research Division

Lindsay Drucker Mann - Goldman Sachs Group Inc., Research Division

Marni Shapiro - The Retail Tracker

Stephanie S. Wissink - Piper Jaffray Companies, Research Division

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

Richard Ellis Jaffe - Stifel, Nicolaus & Co., Inc., Research Division

Jaime M. Katz - Morningstar Inc., Research Division

Pamela Nagler Quintiliano - SunTrust Robinson Humphrey, Inc., Research Division

Rebecca Duval

Howard Tubin - RBC Capital Markets, LLC, Research Division

Dana Lauren Telsey - Telsey Advisory Group LLC

Operator

Thank you for joining us for the Aeropostale conference call to review second quarter 2013 financial results. [Operator Instructions] I would like to remind everyone that this conference call is being recorded. I would now like to introduce Mr. Ken Ohashi, the company's Vice President of Investor and Media Relations.

Kenneth Ohashi

Thank you, all, for joining us this afternoon. With me here today are Tom Johnson, our Chief Executive Officer; Emilia Fabricant, EVP of the Aeropostale brand; and Marc Miller, our Chief Financial Officer. We issued a press release earlier this afternoon announcing second quarter and fiscal 2013 financial results. A copy of the release can be found on our corporate website.

Before we begin, I'd like to remind you that, during this earnings conference call, certain statements and responses to questions may contain forward-looking information, such as forecasts of future business plans, prospects and financial performance that we make pursuant to the Private Securities Litigation Reform Act of 1995. Forward-looking information and statements involve assumptions and known and unknown risks and uncertainties, which may cause our actual results in future periods to differ materially from our forecasted results. Those risks are described in our Annual Report on Form 10-K, as well as in our subsequent filings with the SEC. These filings are available on both our website and the SEC's website.

All forward looking information and statements are made as of the date of this call, and we undertake no obligation to update or revise any forward-looking statements to reflect subsequent events or circumstances. Listeners of this call are referred to those filings.

Before I turn the call over to Tom, I would like to remind everyone that an investor presentation covering our second quarter results can be found on our website. [Operator Instructions] I would now like to turn the call over to Tom.

Thomas P. Johnson

Thank you, Ken. Good afternoon, everyone, and thank you for joining us today. Given our weak second quarter results and our outlook for the back-to-school season, I'd like to take a somewhat different approach to my remarks on today's call.

Before we discuss our performance, I'd like to talk about how we positioned ourselves during the period, particularly back-to-school, and provide additional color surrounding some of our initiatives. Our business trends in the second quarter did not change materially from earlier in the year, which was disappointing given the level of change we've registered with the brand. This performance and the third quarter outlook is being influenced by a challenging retail environment with weak traffic trends and high levels of promotional activity. We believe we've made substantive changes to Aeropostale's product and brand projection. However, the level of customer adoption has been slower than we had expected.

This launch of our back-to-school season represented one of the most comprehensive seasonal strategies Aeropostale has ever had. Our merchandise and marketing plans were intricate and multifaceted, and our organization's execution has been strong. Starting with back-to-school, we took a curated head-to-toe approach to our assortments, deepened our penetration of fashion and entered new categories such as footwear. We also launched our new label, Live Love Dream, which we're very excited about and which Emilia will discuss in more detail.

With our increased focus on fashion, we have aligned our marketing strategies to highlight this merchandise and refine how we're connecting with our customers. Our marketing campaign in the second quarter and in back-to-school included updated imagery, visual collateral capturing the teen's dynamic lifestyle and exciting store events nationwide.

We've also leveraged social media to increase our customer outreach and believe there's further opportunity to connect with the teen consumer through this channel. Some of you may have seen the launch of this year's back-to-school floor set with our Aero Rocks Fashion event. On July 29, we carried out one of the most dynamic marketing campaigns we have ever done in the history of Aeropostale in order to relaunch Aeropostale as the destination for fashion, in addition to our heritage products.

On the morning of the launch, we closed our stores so the field teams could prepare for this event. As many of you saw, we created excitement in the mall, and customers all across the country were lined up to shop at our stores. Connecting with our customer and increasing traffic to our stores and online are important areas of focus for us moving forward.

We believe we've made progress to date with our key initiatives, and we've injected more change into the business in recent periods. Customer adoption has not materialized at that same rate. We're disappointed that our financial recovery is taking longer than we expected. However, we're committed to turning our business around and focusing on changing brand perception and recapturing market share.

Before I turn the call over to Emilia, I would also like to provide a brief update on continued progress with our growth drivers: P.S., e-commerce and international. During the quarter, we opened 19 P.S. stores and introduced the brand in 3 additional states, bringing our total to 142 stores in 31 states and Puerto Rico. P.S. continues to build brand recognition. We remain excited about both the domestic and global opportunities for the brand.

In our e-commerce business, we are pleased with the performance of GoJane, and we've been working diligently to transform the Aeropostale brand through our direct channel as well. We leveraged our e-commerce platform to launch Live Love Dream before it hits stores, and we look for more opportunities to expand our e-commerce reach.

In international, we launched our brand in 3 new countries during the quarter: the Philippines, Panama and Mexico. These openings were important milestones in Aeropostale's international expansion strategy.

I would now like to turn the call over to Emilia who will take us through some of the merchandising highlights for the second quarter.

Emilia Fabricant

Good afternoon, everyone. As Tom mentioned earlier, we operated in a challenging and highly promotional environment during the second quarter, which we are continuing to experience in the initial back-to-school period.

In the second quarter, we increased the penetration of fashion in our stores while reducing the dependency on the down-turning logo businesses, such as graphics and fleece. We were encouraged with the positive trends we experienced in key areas where we added newness, such as wovens, sweaters and footwear. The team did a nice job updating washes and fabrics and truly making the product feel fresh and authentic. Our men's and women's teams work together closely to make sure we had a cohesive collection on the floor. Despite very weak traffic trends, we are encouraged by the higher AURs and healthy sell-throughs we have realized on certain fashion style, while maintaining our value proposition on our core.

As planned, we launched our new label, Live Love Dream, during the second quarter. The Live Love Dream collection, which can be accessed through our website or lld.com, consists of active tops and pants, yoga, lounge, intimates and footwear. LLD focuses on the use of modern, super soft fabrics that are easy to mix and match. We are pleased with the initial results of this business, and we think the new collection truly complements the teenagers' active and dynamic lifestyle.

Operationally, we continue to reduce product lead times and left more open to buy heading into the third quarter. This strategic move will enable us to read and react to trends and flex our business to higher unit velocity category. We also continue to make progress with our assortment planning tools and redistributed our merchandise to smaller pre-packs to distort fashion and basics across our chain.

While I am pleased with the strategic changes we've made to our merchandise assortment and the look and feel of our stores, we still have a lot of work ahead of us. The volume of our fashion merchandise is not enough to offset the declines in our core business, and we look to continue to refine our merchandise mix moving forward. However, our main focus is on traffic-generating initiatives to communicate the changes we've made to our assortments to the consumer. I am confident that we have the right strategies in place, and I look forward to sharing our progress with you in the coming months.

I will now turn the call over to Marc, who will take you through the financials.

Marc D. Miller

Thank you, Emilia. Our miss for the quarter resulted from a double-digit decline in store traffic and continued weakness in some of our core categories. Total net sales for the quarter were down 6% versus last year, reflecting a negative 15% comp, which includes our e-commerce channel, partially offset by an average square footage increase of 3%. Including our e-commerce channel, our guys business was down 12%, and our girls business was down 16% for the quarter.

Our comp for the quarter was driven by a 10% decrease in transactions, a 5% decline in average unit retail and a 1% decrease in units per transaction. During the quarter, we opened 4 Aeropostale and 19 P.S. from Aeropostale stores, and closed 9 Aero and 1 P.S. store, ending the quarter with 977 Aero and 142 P.S. stores.

On a GAAP basis, including store asset impairment charges of $8 million, gross margins for the quarter were 17.9%. On an adjusted basis, excluding the impairment charges, gross margins for the quarter were 19.6% versus 25.3% last year. The 570 basis point decrease was driven by 250 basis points of lower merchandise margins and 320 basis points from the deleveraging of non-merchandise COGS.

On a GAAP basis, including the accounting effect related to the retirement features of our stock-based compensation plan, SG&A for the quarter was 27.5% of sales. On an adjusted basis excluding this item, SG&A for the quarter was 26.9% of sales versus 25.2% last year.

Our tax rate for the quarter was 23.3% versus our original expectation of 45% as a result of lower taxable income for the first half of 2013. This resulted in a net loss of approximately $33.7 million or $0.43 per diluted share. On an adjusted basis, the net loss for the quarter was $26.9 million or $0.34 per diluted share. To put this in perspective, if you were to use the 45% tax rate that was in the original guidance we provided for the second quarter, the loss per share would've been $0.23.

Cash and cash equivalents at the close of the quarter were $100 million versus $170 million last year. Inventory at the end of the quarter was $250 million, up 1% in total or down 3% on a retail per square foot basis and down mid-single digits in units. Our capital expenditures for the quarter were approximately $28 million, and depreciation and amortization was approximately $16 million.

I will now discuss our guidance outlook. Our business quarter to date continues to experience pressure, and we expect the macroeconomic landscape, weak customer sending and heavily promotional environment in the teen retail sector to affect our financial performance. Accordingly, we are initiating guidance for the third quarter at a loss of $0.21 to $0.26 per diluted share. This guidance excludes the impact of any potential store asset impairment charges and assumes a share count of 78.5 million and an effective tax rate of approximately 35.5%.

Before I turn the call back to Tom for his closing remarks, I also want to provide an update on key financial initiatives we outlined at the start of this year in the areas of real estate optimization, expense management and capital expenditures.

As you may recall, at the end of last year, we announced plans to close approximately 100 stores over the next several years, including 15 to 20 to be closed this year. As part of our real estate optimization efforts, we regularly review performance across our store fleet. Accordingly, given the current environment, we have accelerated our plans for this year and now plan to double that number with expected store closures of 30 to 40 stores by year end. We continue to look at our current store fleet critically, and we are reviewing our store closing program to determine whether additional store closings are appropriate. We will discuss the results of this review on a future earnings call.

With regard to expense management, our plans for the year included looking at every discretionary expense across the organization and leveraging our shared services model to realize opportunities for profit improvement. Year-to-date, although we have invested in initiatives pertaining to marketing for Aeropostale, as well as our long-term growth including P.S., GoJane, Live Love Dream and international licensing, our SG&A dollar spend on an adjusted basis is below last year as a result of store labor savings realized from our workforce management tool, as well as our focus on managing headcount and all discretionary expenses.

Finally, while we would typically discuss our capital expenditure plans for 2014 on our year-end call, we would like to note that our team is already reviewing our spending plans for next year. As we look at what we believe are the appropriate levels of investment, we expect to significantly reduce capital expenditures compared to 2013.

Now I will turn the call over to Tom for closing remarks.

Thomas P. Johnson

Thank you, Marc. As we reposition the Aeropostale brand, our current merchandise assortment is more fashionable and we believe more relevant to today's teen. While we're disappointed with our results to date, our entire organization is focused intently on accelerating customer adoption and regaining market share.

We still have a lot of work ahead of us, but we've made progress against our strategic initiatives, which we outlined at the beginning of the year. We have significantly increased the fashion in our merchandise assortment. We have strengthened our team, not only with Emilia coming on board, but also through additional talent in our product development area. We have made changes to our marketing programs, increased our social media presence and updated the projection of our brand in our stores and online, all enabling us to make progress in changing brand perception.

We've made significant improvements in our systems and processes, rolling out workforce management as well as implementing new planning and allocation tools. Financially, we're closely managing our expenses and future CapEx, and our balance sheet remains solid. At the same time, we have continued to focus on growth drivers: P.S., e-commerce and international licensing.

I believe we have the right strategy and team in place to execute on the initiatives that will drive improvement in our performance and long-term sustainable growth. We look forward to sharing our continued progress with you in the coming months.

Operator, we're now ready to take questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Jennifer Black of Jennifer Black & Associates.

Carla White

This is actually Carla White in for Jennifer Black. Can you talk about how the fashion has performed in your A malls versus your B and C malls? And do you feel like you have allocated heritage merchandise appropriately in your B and C malls?

Emilia Fabricant

Sure. Actually, fashion by store type seems to be performing across all of them, though we will be analyzing our store performance and reevaluate -- reevaluating, after this season, our store clusters. As far as heritage doors, as you know, we've implemented -- we started implementing assortment planning, and we actually protected our heritage doors to a heritage mix.

Operator

Our next question comes from Paul Alexander of Bank of America.

Paul Alexander - BofA Merrill Lynch, Research Division

Could you just talk a little bit more about the slow customer adoption? First off, what exactly does that mean? Does that mean that conversion is down in addition to traffic being down? And then in light of the slow customer adoption, I agree. I think the fashion looks better. But what gives you the confidence that you're doing the right thing with the assortment given what you're seeing?

Thomas P. Johnson

Paul, this is Tom. The conversion has been flattish on the year, just very slightly down overall, which we think is okay. We obviously would love the conversion to be a little bit higher, but we do think that we're trading some of the business from a year ago on some of the very, very, very low priced commodity businesses, if you will, like the $5 T-shirt business that we've been in for many, many years. So we do think it's going to take a little bit of time. The good news is we see the fashion, as Emilia alluded to earlier, checking and in some cases, checking very nicely with some very nice AURs, albeit not enough to offset the core product that we've had in the mix for quite some times. And when we -- our confidence level, and that's why we feel confident that we're directionally moving the right way.

Emilia Fabricant

The only thing I would add is we have done an extensive job of getting to know the 14- to 17-year-old teens. And we feel that while the teen has evolved in their fashion preferences, we had not, and we're playing catch-up. So we feel confident that we continuously learn and move with the teenager and remain relevant.

Operator

The next question is from Thomas Filandro of Susquehanna Financial Group.

Thomas A. Filandro - Susquehanna Financial Group, LLLP, Research Division

If I could, Emilia, just going back to this AUR comment that you made, some higher AUR in some of these select fashion items, and Tom mentioned that fashion is checking. Can you give us some magnitude in understanding how strong of an AUR pop you're seeing in some areas? And then to tag on to that, when you mentioned refining the assortment, does that mean pulling back on some fashion broadly? Or what exactly do you mean when you say refining, so we can get a better handle on what to look for go forward?

Emilia Fabricant

Sure. Like-for-like compared to last year, we're actually very similar in AURs. Where we're seeing higher AURs is in either updated categories or categories that we have not carried before, for example, sweaters, authentic outerwear and shoes. As far as refining the assortment, we believe we have an opportunity in the fashion basic assortment. And as we learn more about the reaction of our teenager to the fashion, we'll be able to capitalize in that bucket.

Operator

The next question is from Betty Chen of Wedbush.

Betty Y. Chen - Wedbush Securities Inc., Research Division

Obviously, a very tough environment in terms of traffic. What can we look for from a marketing perspective to continue to kind of entice the customer to come into the stores and check out the new merchandise? And then related to that, just curious, remind us of the inventory buys for the back half if you can and where we should expect inventory plans to be at the end of Q3 and whether the Q3 guide had any impact from the carryover from the second quarter.

Thomas P. Johnson

Sure, Betty. This is Tom. I'll take the marketing, and Marc will take the inventory. From a marketing standpoint, we're -- we won't comment on forward-looking marketing programs, but we are very excited about some of the things that we have in our arsenal. But to date, we have really developed a very nice relationship with Seventeen Magazine and Teen Vogue, a nice partnership. So we've continued to use them in getting our message out there. We've obviously updated the imagery in our stores to really capture the lifestyle of our team. Our social media has been a very nice add to us from a year ago. The social media has grown dramatically and the impact of that, we feel very good about. And last, but not least, I'd like to give a shout out to the field organization. They've done an extraordinary job on a grassroots level. But it's very powerful because they are the teenager, and they are rocking the fashion message out for us. And in our marketing campaign that we held on July 29, when we closed all of our stores or most of our stores across the country, the lines that you saw out in front of our stores is directly due to the marketing of our internal teams. So we will continue to utilize all components of marketing to really change the brand perception overall. We know that we have our work cut out, and after many years of trading in a particular case with hoodies and graphics, which obviously made us a lot of money when hoodies and graphics were in vogue, the uniforms changed dramatically, and we've had to change with it. And as Emilia said, we didn't change to the level and degree fast enough, but we feel that we're getting there. It's just about brand perception change now as far as inventory is concerned.

Marc D. Miller

Yes, Betty. We bought back, back half -- bought back half down double-digits versus LY. And within that double-digit down inventory buy, we did keep open to buy in the mid teens, which we will be very careful about deploying only against true trending classifications. We expect Q3 to end pretty close to in line with where we ended Q2. And the way I characterize Q2 ending inventory is not having a significant overhang that we would need to additionally clear through.

Operator

The next question is from Janet Kloppenburg of JJK Research.

Janet Kloppenburg

Emilia, I was wondering if you could talk about the performance of the denim program that you brought in as such a big revamp versus last year. And also, in the fashion assortment, I was wondering how the knits were performing, not the sweaters per se but the knits, because we're hearing that fashion knits are having trouble across-the-board. And for Marc or Tom, was wondering if you could talk a little bit about August performance and how it's trending versus the July trend and if the comp guidance for the third quarter was about the same as the second.

Emilia Fabricant

Janet, as far as denim, we are happy with the core business, and we are happy with some of the fashion. However, we were up against, last year, a very strong colored fashion denim trend that we have not been able to comp. The other part with knits, knits continue to be challenging. However -- especially in logo. But we've had some successes that we'll be capitalizing on in the back half of the year, for instance, fashion graphics and the long sleeve category.

Marc D. Miller

And Janet, on August performance to date, we've seen decelerating comps from July into the first 3 weeks of August, and the guidance that we provided assumes a continuation of those decelerated comps from Q2.

Operator

The next question is from Randy Konik of Jefferies.

Randal J. Konik - Jefferies LLC, Research Division

So I mean, let's -- if we assume for a moment that these comps don't get better, I think you've made mention of you can take the CapEx, I think, down in 2014. Can you give us some perspective on what's the game plan in terms of what you're going to do if this top line doesn't start to stabilize? I mean, what is going to happen on the expense SG&A side, and what are we going to see on the CapEx side and so forth? Just -- can you just walk us through that exercise?

Marc D. Miller

Sure, Randy. It's Marc. I'll take that one. As we alluded to in the upfront comments, we're looking closely at cash management and overall expense savings, both for this year and beyond. The CapEx that we flashed is kind of early in our budgeting process, but we know we will take down CapEx significantly from where we were in 2013. We're going to end 2013 at about $85 million in CapEx, and we did shave about $4 million off of our initial CapEx targets for 2013. The buckets of CapEx are new stores, format renewals, as well as systems and other maintenance CapEx. And we'll be looking at each one of those buckets, and we'll have more to say on that on our Q4 call. As it relates to expense management, obviously, a very important initiative for us. This year, we kept SG&A flattish year-over-year, and that's despite major investments, strategic investments that we've made in marketing. As we talked about in the upfront remarks, driving traffic to the stores is one of our most important initiatives, as well as registering the fashion change. So we need to preserve and protect that marketing investment. And we've also invested in GoJane, which is a business we didn't have in our SG&A last year, as well as growth in P.S., international, e-com and the launch of a new brand like Live Love Dream. What we've done is we've looked at every discretionary item. And in doing so, for the full year, we pulled about $45 million in spending from what we originally planned to spend this year with some of those strategic investments. As we look to 2014, we will -- especially if the comp trends continue, we will continue to be appropriately cautious. I'm not going to get in to any specific targets right now on SG&A, but you know that we've always been very tight with expense management. And we will continue to operate appropriately if that is the environment that we're facing next year.

Operator

The next question is from Dorothy Lakner of Topeka Capital Markets.

Dorothy S. Lakner - Topeka Capital Markets Inc., Research Division

The stores really do look great despite the results, and the stores did a great job with the opening. So I just wondered, going back to when you debuted the new collection, I saw that people were asking customers questions and so forth about what they thought. So I wondered what you're learning from the customer. Obviously, this whole segment has been pretty difficult. So I'm just wondering what you learned so far in talking to customers who came to the event and just in general, what your perception is of what's going on out there.

Thomas P. Johnson

Sure, Dorothy. I'll take a part of that, and Emilia, I know, would like to jump in as well. It's been -- I was going to use this as my wrap up, but I'm going to cut to the chase. It's really incredibly mixed. I've got tremendous mixed emotion about what's going on right now. I think as an organization, we've done an incredible job of really transforming the brand and appropriately transforming to a place. But results are tough, and the teen sector, obviously, is very troubling. But the reality is that we did many intercepts after the event and even a couple weeks after the event. And we actually literally interviewed people coming out, young girls coming out of the store. And we focused on the teenage girl and ages from 14 to 17, which is our target market. And we had them on video tape. They had no idea who we were. We just said it was a market research company, and the reaction to the product was overwhelming for us, and that many of them said, "We used to shop Aero when we were in middle school. We haven't shopped in a while, but now we're in high school, and we really like what we see." And it was a really great moment for us, and we've done that in a couple different places across the country. So we're pretty excited about the emotional reaction and the anecdotal reaction. Obviously, we need the empirical reaction to follow, and that's our goal. But we feel pretty good about some of the reactions to that and our store teams as well.

Emilia Fabricant

The only thing I'd add is these intercepts and the information that we get from this research is it really is focusing our team to focus on awareness and traffic-driving initiatives. So -- and that's our strategy in the short and long term.

Operator

The next question comes from Edward Yruma of KeyBanc.

Edward J. Yruma - KeyBanc Capital Markets Inc., Research Division

I appreciate your forthrightness in stating that the teen, for whatever reason, may have moved away from your store for some time. I guess, how do you think about the customer base that has been shopping your store over the past couple of years, maybe a slightly older, maybe more diverse customer? How is the new fashion working for them? And then I guess on the side, how should we think about the fashion basics business going forward given that's still an area that needs some assistance?

Emilia Fabricant

Well, like we said before with our assortment planning initiative, we believe we have protected that customer, and we are protecting all customers and we're just trying to grab more of a market share. As far as the fashion basics, as we read and react to the fashion that is selling, it just gives us more knowledge to be more bullish in our fashion basics category, which is, again, like I said, is a big opportunity for us.

Operator

The next question is from Matt McClintock of Barclays.

Matthew McClintock - Barclays Capital, Research Division

Given the sharp contrast between the weak traffic that you're seeing and also the strong e-commerce growth that you're seeing, I thought it might be helpful if you could give us your updated thoughts on the potential of cannibalization of the e-commerce channel. And then secondly, does this shift to online by the consumer potentially opening up to new competitive threats that perhaps are contributing to the intense promotional environment that you're seeing?

Marc D. Miller

Matt, it's Marc. On the overall strong e-com business, I do, as a reminder, want to mention that the e-com business includes our GoJane business, which we didn't have a year ago. And while trends did improve in our core underlying e-com business versus Q1, they're still not as robust as we'd like to see them. In terms of cannibalization, there's not a question that technology and the rise of some online-only pure play fashion retailers is having an impact on all of our businesses. And as we think about how to reach this teenager going forward, it will be an omni-channel approach where we maximize our e-commerce, our social media platforms, as well as our store base. And in some of the remarks that we made upfront just about the stores and store count, I think you're seeing an understanding by us of the fact that, over time, there is a shift that's tending towards e-com, and we want to make sure we're best positioned to take advantage of how the customer's shopping going forward.

Operator

The next question comes from Adrienne Tennant of Janney Capital Markets.

Adrienne Tennant - Janney Montgomery Scott LLC, Research Division

My question is on the guidance. I just was wondering, Marc, did you say that you looked at the SG&A, did you comment that we should think SG&A dollars should be slightly down for the third quarter? And if that's the case, is it correct to assume that the gross margin you're guiding for is similar or just a shade higher than Q2? And then just for Emilia, by our calculations, the penetration of fashion is 20%, 25%. Is that about right for total merchandise? And where do you think it needs to be to really be able to move the needle for the company on whole?

Marc D. Miller

Adrienne, I haven't commented specifically on Q3 SG&A guidance. But for Q3, we do expect SG&A to be up slightly on a dollar spend as a result of the marketing investments that we think we need to make to drive the business, as well as the fact that in Q3 as well as Q4, we're anniversary-ing an incentive comp reversal. So you should, in your models, model up -- dollars spend up by a few million. Embedded in that as well in the guidance is that we do expect increased deleverage on the gross margin line, and that's really a function of the fact that we see decelerating comps in our business, and you see the deleverage impact of that on our non-merchandise COGS, which impacts our overall gross margin rate.

Emilia Fabricant

So as far as the fashion mix, yes, we're about 20% to 25%. While the mix will change from season to season, where you'll see the increase is fashion basics.

Operator

The next question comes from Jay Sole of Morgan Stanley.

Jay Sole - Morgan Stanley, Research Division

This is Jay Sole on for Kimberly Greenberger. I have 2 questions. One is, with the $100 million on the balance sheet and let's just call it below-trend operating cash flow, is it limiting the amount of capital you need to roll out the new look of the stores across the fleet? And would you consider tapping a line of credit, if need be, to accomplish that?

Marc D. Miller

Jay, the $100 million on the balance sheet is certainly lower than we typically are at this point in the year as a result of the declining operating cash flows, as you pointed out. And while we're clearly looking at cash management initiatives, we do believe we need to start the rebuild to get to the appropriate level of cash reserves that we've always talked about, which is about $200 million at year end. The question that goes to new store format is that, should we be accelerating it or is it -- are we constrained in accelerating it? And what I'd say is similar to Tom's commentary about some of the qualitative feedback we got from these store intercepts and focus groups post-launch. We are seeing, qualitatively, really good things out of our new store format. But I think it's really early for us to make a read as to how aggressively to roll them out. Certainly, there are key metrics. The comp performance is running north of what the total chain is in the new store formats, as well as AUR. And as a side note, fashion is selling particularly well in those new format doors. But premature to comment on how we would utilize, potentially, our $175 million line of credit to fund accelerated store remodels.

Operator

The next question is from Anna Andreeva of Oppenheimer.

Anna A. Andreeva - Oppenheimer & Co. Inc., Research Division

Your UPTs declined for the first time really in many years. So as you kind of look out at the next couple of quarters, if the teen space still continues to be difficult, how do you guys think about balancing some of that AUR versus UPT trend? And a question to Emilia, I think you talked about the 14- to 17-year-old customer that you're focusing on earlier, and historically, I think your customer was a younger teen. So are the customer demographics changing? Maybe you can talk about that.

Marc D. Miller

On the UPT decline, I do think it's a little bit a function of the customer transition that's going on. And to be clear, the UPT decline was slight for Q2. So I don't want to over emphasize the point. But we do believe that we need to get full credit in our fashion with higher AURs than what we've been seeing. And that's the path. A bit higher AURs with the right fashion mix with margin structure rebuild is our path to profitability.

Emilia Fabricant

Back to the customer, historically, we have always targeted the 14 to 17 year old. So I think we're sticking with our historical target customer. It's just that they evolved and we were -- we did not. And so we are playing catch-up, but we believe that this is where our customer is today and we are targeting the right age group.

Operator

[Operator Instructions] And the next question is from Lindsay Drucker Mann of Goldman Sachs.

Lindsay Drucker Mann - Goldman Sachs Group Inc., Research Division

I was actually curious if you could give a little more detail on what kind of safety valves you have, as far as liquidity is concerned, in the event that you continue to burn through cash and what -- and whether you have a specific free cash flow forecast for us for the third quarter.

Marc D. Miller

Lindsay, in terms of safety valves, obviously we have the $175 million line of credit, which is untapped at this point in time, and that should help see us through any of our working capital needs over the next few quarters if even needed. The other things that we're looking at in terms of cash conservation we alluded to upfront, our capital expenditures, taking that down significantly for 2014, and we're looking at other cash management initiatives as well. And we won't be providing any free cash flow forecast for the quarter or beyond.

Operator

The next question is from Marni Shapiro of The Retail Tracker.

Marni Shapiro - The Retail Tracker

The stores do look really much better, especially that lead with the fashion. But I'm curious, if you could talk a little bit about, there's been a lot of noise about the price points in the stores on the fashion and resistance, possibly, to those price points. So if you can talk a little bit about that. And then if you can also talk about price points on things like logo, tees and hoodies that you still have in the stores, if you can just talk about that year-on-year, if those prices are the same or if you've increased or decreased those prices at all.

Emilia Fabricant

Marni, as far as price points, like-to-like, we are very similar to last year. Obviously, we pulled in promotions week-to-week. So -- but as a general statement, we are targeting around the same. Where we're seeing better AURs is trending categories like woven tops, overall sweaters -- it's just a different level and quality of a sweater that we're carrying in the store today based on what we had last year, and outerwear. And based on what we're seeing -- and again, it's very soon. So it's in the last 3 weeks, we are seeing higher AURs, and we are seeing a nice velocity in those higher AUR fashion items. But over time and when we look at these items all in, we'll be able to speak more accurately about them.

Thomas P. Johnson

And Marni, just to piggyback on that, I think what you could be seeing, and obviously we're cognizant of it, and what Emilia mentioned in the upfront remarks, I just want to reiterate, we have categories we haven't had in the past. So when we have a real authentic anorak jacket for $40, it may be unusual for -- to see something like that in our store, and the shoes that we've been selling in the store that are $40, $45. So that's -- I think you could be reacting to some of that and clearly, we see it as well. But oddly, they're some of our best checking items. So there is a little bit of a dichotomy happening. And as far as the logo T-shirts are concerned, they're priced structurally very similar to last year. So we haven't done much with regard to core. The only thing that we've done with some of the core, as you've seen and pointed out in your Tracker Report, so thank you very much that you did discover it in the back of Garden State, that we've kind of relocated it. And we think it's in a terrific spot in the store, and we're celebrating the heritage product and we're pricing it structurally very similar to last year with the fleece as well as the graphic T-shirts.

Operator

The next question is from Steph Wissink of Piper Jaffray.

Stephanie S. Wissink - Piper Jaffray Companies, Research Division

One question for us just related to the store closure plans. It sounds like, just given the current run rate of the business, that you've added a higher degree of scrutiny to your closing cycle. If you could talk a little bit more about what you see that looking like here over the next few years versus just the next 6 to 12 months.

Marc D. Miller

Steph, it's premature to give targets on store closures. The general point that we are looking with a higher degree of scrutiny at store closings and at fleet management, given the trends of the business, is an appropriate comment, and we will have a future earnings call where we provide a detailed plan about store closings, but we're not prepared to do that at this moment.

Operator

The next question is from Jennifer Davis of Lazard Capital Markets.

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

Most of my questions have been answered, but I was wondering if you could spend a minute on the trends you're seeing at P.S. It seems to -- it's like those stores are maybe performing a little better. So if you could talk about that.

Thomas P. Johnson

Sure. We feel good about the progress that we've made in P.S. But similar to Aero, the Q1 and Q2 business did decelerate from their trends, where they were from an LY perspective. The good news is some of the recent trends in the business overall, there are some real bright spots, the boys business in particular. Bottoms business has been very strong on both the boys and girls side, particularly in denim, where I think you saw the color denim, and the ponte pant is another item that's been very strong for us. And lastly, similar to Aero, the wovens business on the top side on both girls and boys has been very strong. So overall, we feel good about P.S. and what's happening over there.

Operator

The next question comes from Brian Tunick of JPMorgan.

Unknown Analyst

This is Kate [ph] on for Brian. I was just hoping you could speak to maybe the spread that we're seeing between the AUR in some of the fashion items and just some of those core items, just to get a sense of the lift that you're seeing from the fashion items as they're going out the door.

Emilia Fabricant

Well, as Tom had spoken to before, we're selling shoes for anywhere up to $45, and we're selling T-shirts starting -- and camis starting at $6. So it's a pretty large spread and a pretty large differentiation of product type, and we feel we are able to do this and dress the teen head to toe by giving her these choices.

Operator

The next question comes from Richard Jaffe of Stifel, Nicolaus.

Richard Ellis Jaffe - Stifel, Nicolaus & Co., Inc., Research Division

Guys, you talk about some of the strong response to fashion, and that fashion is a small percentage of your store assortment, perhaps 25%. Looking to fall or the second half, how does the inventory balance going to shift from fashion -- core fashion, basics, from 1H to 2H and how -- therefore, how will you capitalize on some of these fashion successes?

Emilia Fabricant

Well, again, still being very early in the back-to-school results, we are taking the learnings that we are seeing to date and shifting some of our inventory. We're shifting, for example, in denim, we have better trending silhouettes. We've been able to expedite that silhouette and reorder into that and shift out of the slower velocity and that's across all categories. And in addition to that, we're trying to -- fashion will continue to be about 20% to 25%. It will flex season to season. We are aware holiday is more of a gift-giving item-driven business, but we feel we have the right mix going into holiday, but we are adjusting accordingly to what we're seeing today.

Operator

The next question comes from Jaime Katz of Morningstar.

Jaime M. Katz - Morningstar Inc., Research Division

Can you guys elaborate a little bit more on the e-commerce channel and how you guys are seeing that positioned versus the stores. Are you able to maintain pricing a little bit better in the stores versus e-commerce or vice versa?

Marc D. Miller

Sure, Jaime. E-commerce, we try to run as our biggest flagship store. Clearly, it's the window into our brand, and we're very careful to manage pricing, so that the messaging as well as the pricing that we carry online are similar, if not identical, to what we carry in the stores.

Emilia Fabricant

Yes, the only thing I'd add is we are seeing similar trends in product online as we are in-store. Again, we have a very strong woven, outerwear and sweater business, so they're very aligned in that today.

Operator

The next question comes from Pamela Quintiliano of SunTrust.

Pamela Nagler Quintiliano - SunTrust Robinson Humphrey, Inc., Research Division

So just very broad, what do you think is going on with the teens? Because obviously, it's not isolated to you guys. What's different macro-wise this year that's incrementally so much worse and she's just not inspired to go to the mall?

Thomas P. Johnson

Yes, good question, Pamela. And clearly, if we knew that answer, we'd be up 10%. No, I'm kidding. Clearly, the teen sector is challenged, and I think it's a number of different things. One is the promotional activity is high, which you would think would induce more purchases. But what it basically does is lower everybody's AUR, so that's obviously challenging. The teen unemployment is something that some of our peers are talking about. I think it's real. I think that if the teenagers aren't working, they just don't have the disposable dough to go spend on apparel. I do think a couple of other things from an apparel standpoint. Last year, Emilia alluded to it, but there is -- colored denim was big and it was new and it was fresh and it gave a reason for the teenager to head to the mall and pick up another color or two of bottoms. And lastly, though similarly, the woven trend was on the way up and it was peaking and it was against very small numbers from a year ago. So I think there are real things structurally with what's going on with the teenager from unemployment and them not spending as much time in the malls shopping because of the disposable income component, the promotional environment. And lastly, there were some trends last year that were fairly new and emerging, and we're not up -- we are up against that this year.

Operator

The next question comes from Rebecca Duval of BlueFin Research.

Rebecca Duval

Emilia, I just want to go back to -- I know you've answered this several different ways, but I want to talk about the refining of the merchandise mix. And just to get an idea, so you talked about some of the changes, shifting into bestsellers versus the things that were a little weaker. When do you expect us -- that we can see some of those changes in the store? Is it going to be in this quarter, or are we talking holiday quarter?

Emilia Fabricant

Well, right now as far as this quarter through September, we're pretty much baked. We have some chases going on. We were able to actually chase into some things from earlier in Q2, in effect, back-to-school. As the months progress, the assortment does shift and change. However, in holiday, we are adjusting. We're in this new business 3 weeks. We're learning everyday. We are reading, reacting and adjusting as we go.

Operator

The next question is from Howard Tubin of RBC Capital Markets.

Howard Tubin - RBC Capital Markets, LLC, Research Division

Maybe just a question on inventory. I know per foot levels are down 3%, and you said there wasn't a lot of carryover. But don't you think there's an opportunity to maybe cut inventories a bit more aggressively and protect the -- and maybe a little bit more margin on the -- during 3Q and 4Q.

Thomas P. Johnson

Howard, we look very closely at appropriate levels of inventory. And as we pointed out, we did buy down double-digits with a much higher component of open to buy than we've ever had before. As we read and react to trends that we're seeing in the business, we will determine how much of that open to buy to deploy.

Emilia Fabricant

Yes, and just to add, we do have trigger points in our core and some of our businesses that we can reflow and adjust as needed, which gives us additional flexibility other than the current position.

Operator

We have time for one more question. Our next question comes from Dana Telsey of Telsey Advisory Group.

Dana Lauren Telsey - Telsey Advisory Group LLC

Can you talk a little bit about when you think about the gross margin pressure from this quarter, how you plan -- how you think about pricing and the drivers of gross margin for the back half of the year and into next year, how you're dealing with the vendors in this troubled time?

Emilia Fabricant

Well, as far as gross margin, we feel that we have the right mix. We are very competitive in our core. We are -- I'm not going to get into too much detail because of the competitive nature, but we feel we are going to set up for Q4 and the rest of the Q3 appropriately and capitalize on our trending items, as well as our key strategic differentiators as that -- like we have in core.

Thomas P. Johnson

And Dana, as Emilia puts forward the refinements that she spoke about into the merchandise mix, we do see an opportunity in Q4 for AUR expansion despite this very promotional and competitive environment, as we see mix shifts in some of the other investments that Emilia made particularly in Q4 start to pay off.

Operator

That is all the time we have for questions. I'd like to turn the floor back over to management for any additional remarks.

Thomas P. Johnson

Great. Thank you very much everybody for your support and your interest in the call today. And clearly, we're fighting a retail battle, and we want you to know that we are not happy with the current run rate of the business. But we -- and that the teen sector certainly is under a tremendous amount of pressure.

On the flip side, and as I mentioned earlier, when I answered Dorothy's question, while we're not happy with the business, we're very proud of our teams and what they've accomplished from the 2 offices, the New York office as well as the New Jersey office and our field organization. And we know that we are on the right path. We have to continue to make adjustments to our game plan and to win the heart and the emotion of our teenage customers.

So thank you again, and we look forward to catching up with you soon.

Operator

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

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