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Francesca's Holdings (NASDAQ:FRAN)

Q2 2013 Earnings Call

September 04, 2013 8:30 am ET

Executives

Randi Sonenshein - Vice President of Finance & Investor Relations

Neill P. Davis - Chief Executive Officer and Director

Mark J. Vendetti - Chief Financial Officer and Senior Vice President

Theresa Rose Backes - President and Chief Operating Officer

Analysts

Adrienne Tennant - Janney Montgomery Scott LLC, Research Division

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

Randal J. Konik - Jefferies LLC, Research Division

Brian J. Tunick - JP Morgan Chase & Co, Research Division

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

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

Howard Tubin - RBC Capital Markets, LLC, Research Division

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

John D. Kernan - Cowen and Company, LLC, Research Division

Janet Kloppenburg

Laura A. Champine - Canaccord Genuity, Research Division

Lizabeth Dunn - Macquarie Research

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

Mark K. Montagna - Avondale Partners, LLC, Research Division

Operator

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the Francesca's Holdings Corporation's Second Quarter 2013 Earnings Conference Call. As a reminder, today's conference is being recorded. [Operator Instructions] I would now like to turn the conference over to Ms. Randi Sonenshein, Investor Relations with ICR. Please go ahead.

Randi Sonenshein

Good morning, and welcome to Francesca's Second Quarter Fiscal 2013 Conference Call.

Earlier this morning, the company issued a press release outlining the financial and operating results for the second quarter ending August 3, 2013. The following discussions may include forward-looking statements. Please note that actual results may differ materially from those statements. Additional information concerning factors that could cause actual results to differ materially from projected results is contained in the company's filings with the Securities and Exchange Commission.

We will begin today's call with Neill Davis, our Chief Executive Officer, who will comment on our second quarter performance and strategic initiatives. Mark Vendetti, our Chief Financial Officer, will then provide financial highlights of the second quarter, as well as details of our financial outlook for the third quarter and fiscal year 2013. Also included on the call is Theresa Backes, our President and Chief Operating Officer.

Following prepared remarks, we will be pleased to address your questions. As usual, the text of today's conference call, along with detailed management commentary, will be posted to our corporate website.

I'll now turn the call over to Neill.

Neill P. Davis

Thanks for the introduction, Randi, and good morning.

While total sales and earnings per share in the second quarter increased 17% and 18%, respectively, and for the first half of the year increased 22% and 19%, respectively, our performance for the second quarter did not meet our expectations. We experienced a strong start to the quarter and gained momentum through mid-June. However, traffic trends slowed and remained challenging throughout July, which has also continued into August.

Our second quarter comparable sales transactions, which is a proxy for traffic, decreased approximately 4%. However, this decline was largely mitigated by a 3% increase in average transaction values, as gains in our units sold per transaction offset a promotionally led decline in average unit retails.

In terms of our merchandise categories, jewelry continued to deliver the strongest performance, followed by accessories and apparel. Our gifts assortment, which represents 9% of total sales, was the most challenged, declining on a comparable basis in the mid-teens. As a matter of fact, that category itself created a 2% comp drag on the chain-wide whole.

In apparel, we're pleased that the performance in dresses, which represents approximately 40% of our apparel category, improved from the first quarter. However, our fashion tops business, which is also a big component of our apparel business, was soft, given our underrepresentation of summertime wear now silhouettes and fabrications.

During the quarter, we had identified that our tops business needed to be more wear now in summery. However, the lead times to reorder prevented us from fully capturing the trend. In addition, there has not been a dominant fashion trend to drive and chase in apparel category this season.

One of the strengths and differentiating factors of our business model is our ability to be dynamic with our merchandise assortment and quickly adjust our offerings to align with changing trends while offering great value. There are areas of opportunity we will be making -- in which we'll be making updates for in the second half of the year. For instance, we are seeing strong trends in bottoms and will be increasing penetration from 5% to 10% and creating a stronger relationship to fashion tops compared to last year's. We are also making adjustments to our gift category.

Gift sales are a barometer of our customers' impulse for novelty shopping. However, beyond the traffic pressures we are seeing, we recognize the assortment needs to be refined. Therefore, we're shifting emphasis in this category to be more occasions-focused and functional and moving beyond amusement-oriented items. As a matter of fact, the occasions-focused and functional subcategories are performing well today, just certainly don't represent an adequate level of penetration.

In the second quarter, our direct-to-consumer channel continued to grow at a much faster rate than our offline channel, albeit on a small base. This pushed direct-to-consumer penetration total sales up by 80 basis points. Total visitors grew by 27% and conversion improved by 20 basis points, driving the total number of transactions up by 66%. We are focused on providing more content, fashion options and styling advice on our site to better emulate the personal one-on-one Francesca's in-boutique experience she currently enjoys.

Infrastructure investments that we have previously discussed and support of this objective are in process and planned for deployment over the next 12 months.

I also want to point out that our initial efforts in direct-to-consumer direct marketing, opening the Francesca's brand to a larger audience, are resulting in sharply higher levels of productivity than unaided organic DTC traffic. We will be focusing on leveraging this learning to opportunities to drive traffic to our offline presence as well.

We continue to expand our offline boutique base and are broadening our market reach. We have opened, year-to-date, 76 new locations and have planned for 87 for the full fiscal year, bringing the total boutique base to 447, which represents a 24% increase over the prior year base. For fiscal 2014, we have identified 79 new boutique openings thus far, half of which are under letters of intent and the balance under executed lease contracts.

Since 1 year ago, when I on-boarded full time with Francesca's, I have been firm in my belief that building out the infrastructure in support of our boutique growth was a key element of our long-term success and ability to deliver the growth and returns as we've experienced since our IPO in July 2011. Delivering the Francesca's experience, which underlines our boutique expansion and direct-to-consumer initiatives, relies on continuous operational updates and enhancements. Making such enhancements and updates ahead of the curve is important in achieving our longer-term objectives. Incremental to our ongoing efforts, we are making enhancements to our in-store visual presentation. Specifically, we have implemented new boutique design standards by creating an elevated environment that allows her to spot trends more quickly and aligns closer with the distinctive local preferences. We have been testing these protocols in the Houston market this past quarter. And after having received positive customer feedback and improved sales productivity, we'll be rolling the protocol out nationally in the third quarter.

Additionally, we have added to our field leadership structure with a more complete, multi-unit managerial level of direction, training and oversight that can steward all of our boutiques to perform at their most productive levels.

While we anticipate challenges in the near term, given the difficult and choppy traffic trends, we do remain confident about the longer-term prospects for our business. Further, the announcement today of the authorization of a $100 million share repurchase program reflects this confidence in Francesca's business outlook, as well as our financial strength. Our board believes that this is an effective means to enhance shareholder value.

Now let me turn the call over to Mark to review our financial performance in more detail for the second quarter and provide third quarter and full year guidance. Mark?

Mark J. Vendetti

Thanks, Neill, and good morning, everyone.

Total company net sales for the second quarter increased by 17% to $89.6 million. Overall, the company net sales increase was driven by 79 new boutiques opened since the end of the second quarter of fiscal 2012, with 20 opened in the second quarter 2013.

The impact of the adjusted retail calendar impacted total revenue in the second quarter of 2012 by increasing the base total by $0.7 million, or approximately 1%.

Comparable sales decreased 1%, including direct-to-consumer. This compares to a 21% increase in comparable sales in the same period last year, which has been restated to include direct-to-consumer sales. As Neill highlighted in his comments, this decrease was driven by a 4% decrease in comparable transaction volume, which we believe was representative of lower consumer traffic overall. This was offset by a 3% increase in comparable average transaction size. Comparable sales, excluding direct-to-consumer, were down 3% compared to last year.

Net sales in our direct-to-consumer business grew 92% to $1.8 million, with improvements in traffic, conversion and average transaction size. We continue to be very pleased with the performance of our direct-to-consumer business since our upgrades to the website earlier this fiscal year.

We have opened, year-to-date, 76 new locations and have plans for 87 for the full fiscal year, bringing the total boutique base to 447. In the first quarter, the store productivity in our 56 new locations performed above the chain average. However, in the second quarter, the performance in the 76 stores opened to date were below chain average, although still within 10% of same-store sales productivity. We attribute the slowdown in relative performance of new locations from Q1 to Q2 largely to the dynamics of 10 new college market locations and stronger first quarter grand-opening cycles, which were not realized in the Q2 openings.

Gross profit as a percentage of sales declined 140 basis points to 53.3% due to a reduction in merchandise margins and deleverage on occupancy costs. Reduced merchandise margins of 80 basis points reflect higher levels of promotion compared to the prior year, particularly in July. The adjusted retail calendar shift created 20 basis points of reduced margin in the second quarter.

We made the choice to increase promotions during the quarter, given the aggressive promotional environment and the slowing sales trends mid-quarter. While we are not in the practice of reacting to peer promotions, we believe that it was necessary this quarter in order to maintain competitive relevance in a challenging environment. Our occupancy costs delevered 60 basis points.

Selling, general and administrative expenses increased 13% to $23.7 million compared to the prior year period of $20.9 million. As a percentage of net sales, SG&A was 26.4% versus 27.4% of sales in the prior year quarter. Within our SG&A, selling delevered by 16 basis points. G&A expenses were flat when compared to the prior year.

Income from operations for the quarter increased by 15% to $24.1 million, with an operating profit margin of 26.9% as compared to the 27.3% in the prior year period.

Net income increased 16% to $14.6 million, or $0.33 per diluted share, compared to $12.07 million, or $0.28 per diluted share, in the prior year period.

Turning to the balance sheet. Total inventory at the end of the quarter increased by $6.2 million, to $25.6 million. Ending inventory was up 32%. Given our 4- to 12-week lead times and the timing of Q2's miss to the forecast at the latter part of the quarter, we could not adjust immediate inbound merchandise levels to the reduced demand within the second quarter. As we manage current Q3 performance, we are actively working through our open divide to align Q3 ending inventories to our forward-looking Q4 revenue projections. Our current inventories contain some carryover of Q2 inventory, particularly in accessories and fashion tops, creating moderate merchandise margin pressure of approximately 50 basis points compared to the third quarter of 2012.

We ended the quarter with $39.5 million in cash and cash equivalents, an increase from $7.3 million at the end of the prior year quarter and $29.9 million at the end of 2012.

Our cash balances continue to grow as a result of the high cash returns generated by our boutiques, with four-wall contributions in the mid-30% range and new boutique return on invested capital greater than 150% in the first year. In addition, the company had no long-term debt at the end of the quarter compared to $5 million at the end of the prior quarter.

In connection with the share repurchase program, we announced today that we have amended our senior revolving credit facility by increasing availability up to a maximum of $100 million from the previous level of $65 million. We extended the maturity for an additional 5 years, to 2018, and then negotiated enhanced flexibility within the terms and conditions. This expanded capacity, along with the company's existing liquidity and significant free cash flow from operations, will support the company's ongoing strategic growth objectives and share repurchase activity.

Now turning to third quarter and full year guidance. Given the anniversary of strong prior year growth rates, lower levels of customer traffic and the lack of a dominant apparel fashion trend, we are reducing our expectations for the second half of 2013.

For the third quarter, we expect net sales to be between $78 million and $80 million, an increase of 8% to 11% over the prior year, assuming a minus 5% to minus 2% comparable sales decrease compared to a 17% comparable sales increase in the third quarter of last year.

Additionally, we will open 11 new boutiques during the quarter. Please take note that the adjusted retail calendar impacts the third quarter by reducing the 2012 base volume by $2.5 million as a higher-volume back-to-school week shifted out of Q3 into Q2 and is replaced by a lower volume week of Halloween. Note the adjusted retail calendar impacts the full year by increasing 2012 base volume by $0.4 million.

Net earnings per diluted share are expected to be in the range of $0.19 to $0.21 compared to third quarter 2012 adjusted earnings per diluted share of $0.24. Last year's adjusted earnings included $0.2 million for the relocation of our headquarters and distribution facility. The number of diluted average shares outstanding, excluding the impact of the share repurchase program, is expected to be $45 million for the third quarter.

Moving to the full fiscal year 2013, keep in mind that fiscal year 2012 was a 53-week year. The incremental 53rd week in 2012 contributed $3.9 million in net sales and approximately $0.03 per diluted share in earnings. For the 2013 fiscal year, we now expect net sales to be in the range of $343 million to $349.5 million, an increase of 17% to 20% over the prior 52-week period in 2012. Comparable sales, including DTC, are now expected to be in the range of minus 2% to flat for the 2013 fiscal year period compared to plus 16% for the 2012 fiscal year comparable sales. We plan to open 87 new boutiques. Approximately half of those will be mall-based and the remaining, non-mall-based. Adjusted net earnings per diluted share are now expected to be in the range of $1.10 to $1.16. This compares to the 52-week prior year adjusted diluted earnings of $1.04. This year's adjusted earnings exclude $0.6 million net of tax for a secondary equity offering in the first quarter. Last year's adjusted earnings included, net of tax, $0.5 million for a secondary equity offering, $0.2 million related to stock option accelerated -- acceleration expenses and $0.2 million for the relocation of our headquarters and distribution facility. The number of diluted shares outstanding, excluding the impact of the share repurchase program, is expected to be 45 million for the full year.

The effective tax rate is estimated to be 39.3% for the third quarter and the full year. Capital expenditures for the full year are planned in the range of $22 million to $25 million.

Our guidance reflects our continued commitment to invest in our growth initiatives related to boutique expansion to 900 U.S. locations, our direct-to-consumer business and operational refinements. We are well positioned and focused on creating the appropriate infrastructure to undergird our long-term growth, even in a period of lower sales expectations.

That concludes our prepared comments for the quarter, and we will now take your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Adrienne Tennant with Janney Capital Markets.

Adrienne Tennant - Janney Montgomery Scott LLC, Research Division

Talk about what your current August month-to-date comps are running. It looks like, to us, that maybe you had pulled back on some of those storewide promotions that you were running. I'm just wondering if there's a change in philosophy. Because there is no traffic, maybe to pull back on promotions or maybe we're just seeing it incorrectly. And then with regards to the inventory, you had said that, by the end of the third quarter, you would be more in line with the sales. Is there any ability to do that a little bit sooner within the third quarter? If you can just address this, that would be great.

Neill P. Davis

Adrienne, this is Neill. I'll take the first part of the question concerning August performance and promotional cadence and Mark will step in with the inventory dynamic. Our August results, on a comp basis, are in line with the comp range that Mark had given for the full quarter. The cadence of our business going through back-to-school was more challenged in the first part of the month. However, it improved materially from the first part of the month. So the implication then is that we've had a pretty challenging start to back-to-school, which we did. However, it abated as we went through the month. I will tell you that, historically, we have seen opportunities to chase in back-to-school seasons. We just didn't see those opportunities. So that was absent in the mix of our business this year versus last year. As it relates to our promotional cadence, we really -- we hadn't really -- one thing we haven't done is done an all-store promotion. We're targeted by category. We're targeted by our needs for clearance items as we transition through seasons, and I know that a lot evaluate our business by going into our boutiques to see how we are positioning from a promotional standpoint. What everyone should understand is that, that does not always mean we're doing that across the entire system. There are certain boutiques that we have an ability to be manuscripted down to the singular level to aid and/or enhance that individual boutique's performance. So I would caution those to extrapolate what you might see in a singular store or group of stores, it doesn't necessarily mean broad based. Having said that, we are driven by the BOGOs, the category-specifics in percentage-off clearance, wherever we need to be as we go from one season to the next. Mark, on inventory?

Mark J. Vendetti

So yes, Adrienne, this kind of builds off of Neill's comments on the promotional activity. So in the areas where the inventory is higher than we would like it, you will see additional clearance-related activity during the quarter that, given our plans, again, we expect them to gradually, from a clearance perspective, take clearance inventory down as we move through the quarter and better align us for the start of the fourth quarter. It will -- again, going to Neill's point, we'll focus a lot of those promotions on the areas where the inventory is in not the best position and try to be very surgical as we go through that. And the guidance we've given, the 50 basis points in the quarter, is reflected in our outlook for the third quarter. And so we expect there will be a gradual improvement during the course of the quarter.

Adrienne Tennant - Janney Montgomery Scott LLC, Research Division

Okay. And just very lastly, the guidance, and unless I'm doing something wrong on the third quarter, the 50 basis points of merch margin pressure, but my gross margins are down like 500, 600 basis points. I'm assuming SG&A is sort of up mid-teens in dollars, so unless there is something weird going on with my SG&A, that seems -- am I in the right ballpark? Because that seems really aggressive in terms of the deleverage on a negative mid-single. Is that -- I was just wondering if you could comment if I'm like off base here.

Mark J. Vendetti

Adrienne, are you talking gross margin or just operating margins?

Adrienne Tennant - Janney Montgomery Scott LLC, Research Division

Gross -- total gross margins, externally reported gross margins, including the deleverage. I've got it at, like, 47% to get to your $0.19, 47%. We can do this offline.

Neill P. Davis

We can take a look. I will tell you, for the benefit for the rest of the group listening to this, that kind of margin compression at the gross line is not the case. So it's -- there must be some dynamic we can chat about.

Operator

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

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

Let me first say that I believe the specialty store traffic declined about 4% in the second quarter. So once again, you did fare better than most. But my question is actually a couple. Theresa or Sei Jin, if you're there, were there any fashion trends you feel like you missed or maybe didn't have enough of, such as peplum or hi-low hems? And then regarding gifts, I'm wondering if gift sales were weaker largely due to the decline in traffic, especially because it is kind of an impulse purchase. I guess, what gives you reason to believe that some of the more whimsical items are, I don't know -- that you need to change that strategy a little bit?

Neill P. Davis

This is Neill. I'll take the gift question and I'll ask Theresa to step in on the apparel question. As it relates to gifts, the category is generally impulse, and we do need traffic to move that along during the season. So that, coupled with the fact that I believe we have overstayed our welcome as a category with the whimsical nature of the collection as a whole, we're still focused on functional and fun and uniqueness in the category, and there are several subcategories within the mix that are working, but we have too heavy of a penetration of the whimsy. So we're working to transition that assortment to what is working. That will take several quarters for that to happen. It's reflected in our financial outlook, as we do that. So as we step into the spring of 2014, I feel very good about what the merch is going to be able to bring to the table and the responsiveness of our customers. So weak traffic trends and the category itself being overextended with where it was has been the big issue there. But nevertheless, we believe that there's going to be some improvements. We can move through that. We'll take a couple of quarters and get that part of our business back in line, so that we don't have the kind of drag we're having here in this quarter on next.

Theresa Rose Backes

So, Jennifer, regarding fashion trends, so last quarter, we identified the maxi dresses being dominant within the dress area, so we chased into that. We were successful in chasing into that and getting some additional inventory into boutiques. We did see there was some shift into wear-now summer tops. Unfortunately, there was really not a lot of availability for that in the market, so we were unable to chase as much as we would have wanted to chase in that category. And so for the most part, we saw somewhat of a shift from dresses into separate mid-quarter and we chased what we could, what was available.

Operator

Our next question comes from Randal Konik with Jefferies.

Randal J. Konik - Jefferies LLC, Research Division

So I guess, my question is, we've seen more of -- this is going to be the third quarter that gross margins are down. There's just a little bit more volatility in the business. How are we supposed to be thinking about the long-term kind of margin structure of the business from a gross margin and SG&A standpoint? Obviously, you hit almost 27% last year from an operating income margin perspective. That's kind of -- that's coming down this year. So I guess, obviously, the big question on the street is going to be where do long-term operating margins settle out? Was 27% too high? Where should these margins be on a long-term basis? Any perspective there would be helpful.

Neill P. Davis

Randy, it's Neill. The longer-term point of view, as it relates to our business, is clearly intact as it relates to new boutiques. So the 900 market size, it still remains very well grounded and we're in hot pursuit of that over the next several years. As it relates to the comparable boutiques as we build the base, as we said, going into the IPO several years ago, the longer-term comp profile is in a 3% range. I mean, even with the stress, apparent stress, of the third quarter comp, on a comparable base, 2-year stag basis, we're still well above those numbers. So I think it is reasonable for one to think that we can do at least that level of comp rate. The translation then to our operating margin structure is that we believe that a mid-20s is a very reasonable number for us to sustain longer term. There are some variations clearly with that on the front end, as we invest in the business, as we talked about. I understand that. However, those are not annual investments that we make over the long term and it will get those leverage points as we move through. But I believe very strongly that the profile -- that the longer-term structure is still there, and those, we're moving forward.

Randal J. Konik - Jefferies LLC, Research Division

Can I follow up?

Neill P. Davis

Go ahead.

Randal J. Konik - Jefferies LLC, Research Division

Has anything changed in terms of, as you're getting bigger, there's more volatility coming into the business with how you're ordering -- having to order inventories in higher quantities, et cetera? Does that impact how we should be thinking about the gross margin part of the business versus the SG&A part of the business?

Neill P. Davis

No. Randy, I think that our gross margin structure -- I mean, there's the 2 basic buckets. There's the fixed cost of our boutiques and then the direct margin of the business. Those numbers are -- can vary, as you're seeing now, for the reasons that they're varying. But we're not talking significant variations by any stretch. I don't see that changing. Unfortunately, you're getting visibility down to quarter-to-quarter movements. And when we transition to back-to-school type seasons, if it's working well, then it's working well. If it's not, you're going to have a little more stress in terms of margin. But these are not very difficult stress points. I mean, I think they're very manageable and we'll move through these. So to answer your question, broadly, the gross margin structure doesn't change. And our investment rate in terms of SG&A, we're trying to manage that as best we can to the top line. We make estimates as to what we think that comp base is for the year. This year, going into the year, we were a little aggressive on what that is, and as a result, you're seeing some current year deleverage that I expect to get back next year.

Operator

Our next question comes from Brian Tunick with JPMorgan.

Brian J. Tunick - JP Morgan Chase & Co, Research Division

I guess 3 quick questions. If you can maybe remind us on the investment front from the systems, infrastructure and DTC how much, in either dollars or comp leverage points, you guys are spending over the next couple of quarters here. Second question, maybe, on the real estate side. Mark talked about the college locations being weak, I think, but can you maybe talk about the mall versus non-mall? Any big differences in the quarter? And then third one is on the buyback side. I know there's no expiration, but can you maybe give us an idea of a minimum cash position that you'd like to carry with?

Neill P. Davis

Brian, as it relates to -- what was the first part of the question?

Theresa Rose Backes

The IT costs.

Neill P. Davis

Oh, the capital investments in our direct business. What we've talked about in past still holds. We're talking somewhere between $10 million to $15 million in capital spending. That gets layered in between now and mid-year next year, which is the time frame where we expect to roll out the future presence of our online store, so to speak. So that hasn't changed, and that's the rate then. You hear what the growth rates are in terms of transactions and traffic, and we're hoping to continue to build on those and continue to drive the much stronger in a much faster rate of growth in that source of business than our offline stores. So really, nothing changing there. Just making sure that we're timely in the spend, timely in the delivery of that presence so we can continue to deliver those top line numbers and capture a greater share of wallet and top-of-mind. Do you want to talk about the...

Theresa Rose Backes

Mall versus the...

Mark J. Vendetti

So on the mall versus non-mall, we did see a slight difference in the transactional comps between the mall and non-mall. The mall held up better during the quarter than the non-malls. And our internal thinking is there is an element of the promotional nature, which is actually driving more people toward the malls and away from non-malls. And even within our non-mall environment, we saw differences in our anchored versus unanchored performance, where the unanchored non-mall environments performed lower. So again, we think that's an indication of traffic in some of the competitive environments going on. And then on your last question, as we talked about the share repurchase and minimum liquidity, when we roll in, we ended with $40 million. But we've upsized our revolving credit facility, so we have $140 million of available liquidity. I'm not going to tell you a specific low-end range of where we think our liquidity is set up. But between the way we're generating cash in the $100 million credit facility, we think we have plenty of liquidity to run the business on a day-to-day basis and fund all of the investments we need to make to continue to grow the business, as well as to make meaningful share repurchases, again, depending on market conditions and other factors.

Operator

And we'll move on to our next question from Tom Filandro with Susquehanna Financial Group.

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

Can -- I guess this is Neill or Theresa. Can you expand on the bottoms comment that you made? I think I heard you said that you're moving from 5% to 10% of the mix, offering a better balance of tops to bottoms ratio. So I'm curious what the tops-to-bottoms ratio currently is. What do you believe the right ratio should be? And will you be able to deliver bottoms on a typical 4- to 12-week cycle? And just a quick one for Mark. With the ATV growth was a result -- I think you guys -- Neill said of higher UPTs and lower AUR, is it fair to assume that, that is the -- built into the go-forward guidance?

Neill P. Davis

Theresa will take the...

Theresa Rose Backes

Yes. So regarding your question about bottoms. So separates really started to present themselves mid-quarter as being an important part of the fall look. And I think you can see with us, as well as our competitors, that there's an emphasis on denim, punky pants, pattern pants really are presenting themselves as a wear-now and a sort of a must-have staple for the fall. So last year, we had a tops-to-bottom penetration of 4:1. This year, we'll increase that penetration, so the tops-to-bottom ratio will be about 3:1. And I think you're going to see that continue for the back half of the year.

Mark J. Vendetti

The best way to think about the discussion on AUR, again, is for the third quarter as we try to manage the inventory and the clearance down to a level we're more comfortable with, you're going to see potentially some AUR pressure in the third quarter again, which we have built into the guidance we provided in the form of that 50-basis-points pressure on the merchandise margins during the quarter.

Neill P. Davis

But then again, I also feel that the UPTs will be reasonable. They'll be healthy.

Mark J. Vendetti

Yes.

Neill P. Davis

For some of the reasons, Theresa just mentioned, relative to trying to be trend-appropriate in the separates and bottoms business, and as we clear through. So the delta then is it's a continuation of those traffic trends that are choppy and difficult to discern meaningful trends.

Operator

We'll take our next question from Betty Chen with Wedbush Securities.

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

I was wondering, Neill, if you can talk a little bit about the new store format that you will be doing after a test in the second quarter. Could you give us a sense roughly how much that may cost and when that could be completed if that would be rolled out to the overall chain? And then I think to Mark's comment, can you give us a little bit more color on bit of what happened to the new store performance in the second quarter? I think you mentioned that they were sort of running above in Q1 and then sort of softened in the second quarter. More color around that would be helpful.

Neill P. Davis

It's Neill. As it relates to the cost of the in-store experience, it's very minimal. We're re-purposing a lot of the internal fixtures. The incremental cost -- there are some incremental costs in terms of fixturing, but it's nominal. And then the other part of the costs is incremental payroll, just hours necessary for boutiques to manage through that assortment. But I would rather Theresa talk a little bit more about what that design means. So, Theresa, if you would?

Theresa Rose Backes

Betty, so the refraction, we call re-imagine of the visual presentation, in the boutiques was really sort of twofold. One was to provide a heightened level of interest in the great product that we have through somewhat of a simpler, more a straightforward visual presentation, fewer props, easier to shop, the ability to put out slightly more product. And then the second was to really draw her attention to the trends that did exist. So where we were presenting, let's say, maxi dresses, we dedicated an area so that she would find those easily rather than to have to do a complete treasure hunt around the space. In jewelry, where there were some very clear silhouettes that were hitting, we wanted to show her what those were. We wanted to show her that we had these items that she was ultimately looking for. So we did try it in Houston. We turned over the boutiques in Houston. We had positive results both from the customers and as well as our employee base, who said the boutique was much easier for them to merchandise and to keep fresh. And so we have gone through a process of rolling out across the chain, and that will continue through the third quarter.

Mark J. Vendetti

And so the -- I'll expand a little bit on the 2 dynamics in the second quarter. So on the college boutique front, the boutiques that opened in Q1 that were in the college towns got off to extraordinary starts, and they were well above the average we would see for our normal comping store. And then once we moved beyond the, I'll call it, the college -- the end of the year ended for colleges and they went to their summer breaks, we saw a very large drop in sales for those boutiques, again, on a relative basis. These college boutiques are still among some of the best-performing boutiques we have and are generally well above the boutique average. And the magnitude of the decline was just larger than we had anticipated. On the Q2 openings, some of it were -- we had quite a few Q2 openings off-mall and non-mall locations, and I think they experienced much of the same lower traffic that we attributed or saw in our existing boutiques in non-mall locations. And they got off to a, I guess, slower start than we had anticipated. Although, again, on a relative basis, they're in the norm that we have generally seen as we've opened boutiques, and we'll continue to watch them closely as we move through the back half of the year.

Operator

Our next question comes from Howard Tubin with RBC Capital Markets.

Howard Tubin - RBC Capital Markets, LLC, Research Division

In terms of trying to drive some traffic in through Q1 and for holiday, do you -- anything -- do you have anything planned maybe besides kind of price-related promotions on the -- like on the marketing front or social media front or e-mail or anything like that?

Neill P. Davis

Yes. I don't mean to be coy. But for competitive reasons, I'd rather not be overly articulate about what we're doing. Suffice it to say, call it -- I'll direct you back to my comment about what our initial results in terms of SEM [ph] have been, not only to driving sharply new traffic. It is -- that traffic comes to us at a much higher conversion rate than what we are experiencing when we leave them on their own to explore. So we have funding in our numbers in the back half to continue to pursue that. We're being relatively conservative in terms of realization of what we might get in relationship in return on that ad spend, but it's positive and we'll lean into this. And we will consider things we might be able to do for the Francesca's brand in the holiday season outside of our brick-and-mortar that would be other social in nature, no traditional broad-based-type media, but certainly one that's more closely aligned with how she maneuvers through that space. So yes, there are some things, and we're on the front end of that. And it's not just the holiday we're focused in on. This is a longer-term, broader strategy, but this is the preamble to the future.

Operator

Our next question comes from Richard Jaffe with Stifel.

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

Just a follow-up, Neill, on what you've seen at retail regarding the different real estate sites. Any change or any -- I guess, well, changing your thinking or your strategy regarding real estate, given the greater strength in malls and the weakness in the non-anchored outdoor centers?

Neill P. Davis

No, there's not a change that relates to that type of venue, mall/non-mall and the various classes of the non-mall. What's really going to be different as we look -- as we move forward for next several years is our outlet penetration. We have 3 today, and they're all in Texas and they're all performing above our expectations. We like the productivity. We like the relative profitability, and the absolute dollars they're throwing off. And our real estate team is looking actively to make that a greater penetration of our overall openings over the next several years so we can continue

to move into that type of real estate. So that's really the only delta or change that's happening near term.

Operator

Our next question comes from John Kernan with Cowin.

John D. Kernan - Cowen and Company, LLC, Research Division

Just wanted to go back again to the long-term margin question. What do you think a normalized SG&A rate as a percent of sales is? You still leveraged SG&A in the quarter on a negative comp, so I'm just trying to understand a long-term SG&A rate. Is it in the mid-20s? Is it in the low 20s? How do you see that developing? And then is there anything about the competitive set that's changed, so other than just the slow traffic environment that's causing a lot of promotions for everybody? Are there any new emerging threats that you've seen pop up this year?

Neill P. Davis

I don't quite recall the second question, but I was sitting here reflecting on your first question. So I'll ask my teammates here to pick up on your second one. But relative to that longer term, there are 2 buckets in terms of our SG&A structure. The dominant piece is what's necessary to support our boutiques in the field. That number of high expectations will be in the high teens. As it relates to the balance, basically G&A and infrastructure, it will largely depend on the pace and the timing and growth of that comparable growth rate, but I fully expect us to realize leverage off of that. It's slightly -- it's in the low-double-digits-today-ish, and I expect it to be slightly below that level as we move outside of your type time frame. I don't know what the other question...

Theresa Rose Backes

So your second question was, are we seeing anything competitive pressures outside of the promotional environment. I would say we haven't, but I don't want to discount the fact that the promotional environment has been pretty significant in the last quarter, up to some boutiques in main line retailers that, up until now, have not been promotional at all. So we haven't seen anything dominant crop up.

Operator

Our next question comes from Janet Kloppenburg for JJK Research.

Janet Kloppenburg

Just a few questions I'm unclear on. Neill, are you suggesting that if you take out the decline in the gift comp, that your comp was -- for the quarter was actually near flat? I need some clarification on that. And if you could tell us if the gift business has improved at all or perhaps it's deteriorate, what the expectation is there for the third quarter. Mark, I was unclear on the inventory levels. Should they be in line at the third quarter? I would think that this kind of third quarter guidance that you would be bringing them down to appropriate levels, but I'm not sure that's right. And in the tops business, I was wondering if you have identified the correct assortment or if you're still in a test-and-refine mode. And lastly, on expenses, Neill, it sounds like they're going up because you are putting some effort into redesigning the stores. I was wondering if there's any opportunity elsewhere to bring the expense line down.

Neill P. Davis

It's a long list. The first one, I'll take, relative to gifts. Yes, you heard me correctly. If we were not challenged with the gift dynamic, as we've spoken to, our chain-wide average comp would've been up 1%, not necessarily flat. So it's a 2-point drag to the negative line that we produced. As it relates to the trending in the category, we're seeing gradual improvement. And as I said, it will take the better part of the next 2 quarters to be appropriately positioned as desired. And most of that benefit -- or most of the impact of that transition will manifest in the fourth quarter, not third quarter. So there is the expectation inherent in our outlook that we'll see some improvements. But we do believe it will continue to be comping down for the back half of the year; less so fourth quarter than third; and then the first half of next year, getting back to a category that contributes to the whole.

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

And regarding the tops business. So we have seen, for the fall season, some dominant looks in tops in embellishments. So embellished tees, mixed material tops, denim shirts were significant for back-to-school. But moving into the fall, we do have a position in the boutiques. We have had early -- good early reads on our sweater assortment. So we have those in all boutiques, and we have those in varying styles and fabrications. So we feel confident about our tops assortment for the back half of the year.

Janet Kloppenburg

On the inventory, Mark?

Mark J. Vendetti

And then on inventory, Janet, so I think the key is our Q3 ending inventory, we're really viewing that in relationship to what we think our Q4 sales are going to be. So in terms of doing the -- is inventory up relative to our Q3 sales number? It will be, but we're more managing toward where we think our sales are going to be going forward into the fourth quarter and making sure we have the right inventory assortments as we move into the fourth quarter. And just one other point, again, to consider is that with the retail calendar, the third quarter ends a week later this year than last year. And so that period is when we really start to build inventory as we go into the fourth quarter. So that also will play a part in the inventory we report at the end of Q3.

Neill P. Davis

And, Janet, as to your last question on expenses, are there opportunities in the quarter, at least the short term. I would suggest to you no. What we have been able to be under expectation for the first 2 quarters largely due to basically unsealed and open positions that were established at the beginning of the year that I am now directing towards efforts, such as Theresa's pursuing with her multi-unit organization. It's not a significant amount. We're doing a lot of this from promotions within and leveraging the infrastructure and challenging our people a little harder, but I don't see there being -- there's not a lot of variability in this expense structure to obviate a comp structure when it goes as -- off sooner as it has been. I mean, that's just -- that's unfortunate. But anything else that I cut in terms of expenses would be getting to the essence of the foundation, and I'm not going to do that.

Operator

Our next question comes from Laura Champine with Canaccord.

Laura A. Champine - Canaccord Genuity, Research Division

The implied revenue guidance in the fourth quarter is obviously below what we had expected. Can you comment on what categories are driving the weakness there, assuming it's also below your original internal projections?

Neill P. Davis

It's still a continuation of apparel and gift. Gift, for the reasons we've touched on numerous times here. And then, secondarily, apparel, primarily because of the traffic trends. We're -- are we conservatively extrapolating the back-to-school experience in the back half conservatively? And might it change? Maybe. But I believe it's an appropriate outlook to take as we look at this. So those are the dynamics that are influencing the fourth quarter.

Operator

Our next question comes from Liz Dunn with Macquarie.

Lizabeth Dunn - Macquarie Research

Just a few follow-up questions. I guess, first, just a follow-up on Adrienne's question. I'm also looking at sort of a 550- to 750-basis-point decline in operating margin in the third quarter, roughly, to get to your guidance based on your sales guidance. So if it's not gross margin, then that implies that SG&A growth is much higher than the first half. And I apologize if I miss it, but -- if I missed it, but exactly why is it accelerating so much?

Neill P. Davis

Well, before Mark answers that, so to be clear, you're talking about operating margin, which I understand. Adrienne was talking about gross profit margin. And what's happening here is, when we go to the comp structure as we did, we get an outsized deleverage in terms of occupancy, and that's influencing the gross margin. Outside of that, I think Mark's given you some color around what we're doing in terms of merchandise margins, which then means the bulk of that operating margin compression is coming out of SG&A. Anything else you want to...?

Lizabeth Dunn - Macquarie Research

Yes, which just looks like a higher growth rate than what we have been witnessing. So go ahead. I'm sorry.

Neill P. Davis

And the only thing -- Mark, the only thing I would follow up is the nuance of some of those nonrecurring expenses in the prior year that benefited second quarter and then got back on track in the third quarter. But...

Mark J. Vendetti

And I would just say, the last piece, it's -- from an investment perspective, some of the things Neill had alluded to in terms of investment and spending behind whether it's DTC or what we're doing in the field, organization, those expenses are fully baked into our third quarter. And given some timing shift, it really didn't materialize in the second quarter. And you really have a function of sales not increasing to the rate that the G&A is increasing just within the quarter. And again, that could go -- again, we're not going to slow down the appropriate investments on a quarter-by-quarter basis. It's probably better to look at that G&A number over the entire fiscal year and not get into the choppiness that might occur on a quarterly basis.

Lizabeth Dunn - Macquarie Research

Okay. Relative to the $2.5 million that you called out in sales hit from just the calendar shift, that's not in comp, right? So that's like about a 3-point hit to the total sales growth in the third quarter? Is that the right way to think about it?

Mark J. Vendetti

Yes.

Lizabeth Dunn - Macquarie Research

Okay. And then just finally on inventory. Again, I apologize if I missed it, but is there anything in these inventory numbers that relates just to the shift in timing of the calendar, as a lot of other retailers have called out, for a portion of the increase?

Neill P. Davis

For the ending second quarter, it was very minor. The end of the third quarter, that week will be a much larger impact than what we saw in the second quarter.

Operator

Our next question comes from Edward Yruma with Keybanc Capital Markets.

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

Just one quick question on the follow-up on the bottoms business. Could you kind of just assure us that -- how do you feel about the quality and the depth of the relationships with some of these bottoms vendors? Are you having to expand your vendor base? And I guess, I believe it was about 1.5 years ago you had some missteps with denim. How has that illuminated maybe some of the things you're doing in bottoms today?

Neill P. Davis

It certainly has allowed us to better query and work the vendor market and our merchants. I believe, relative to the product that's in the store today that's being branded underneath our sub-brand, Harper, is an outstanding garment in terms of fabrication and fit, and we're certainly seeing our customer respond likewise. So we were pursuing that solution last year in terms of the vendor. Now you're seeing the results of what they have been able to do to put it on the table. So we're -- it's been a plus. Did that answer your question?

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

Yes.

Operator

We'll take our next question from Mark Montagna with Avondale Partners.

Mark K. Montagna - Avondale Partners, LLC, Research Division

Just regarding gifts, if you look at the Q3 guidance, $0.19 to $0.31 versus consensus $0.30, is it fair to estimate that maybe half of that missed expectations is related to the gift category?

Neill P. Davis

For the third quarter?

Mark K. Montagna - Avondale Partners, LLC, Research Division

Yes.

Neill P. Davis

Mark, I mean, I don't give that level of flow-through dynamics in terms of the business. I guess you should orient your thinking as it relates to the comment I made about how it compressed our business in the second quarter. I expect there to be continuing weight in the third quarter, not exactly the same as the second, but close. And then it downgrades from there into the fourth quarter, but a drag, nonetheless. So I mean, hopefully, that can help you to think about your model in terms that you've asked. But I can't get to that flow-through-type margin question very easily.

Mark K. Montagna - Avondale Partners, LLC, Research Division

Yes, that's helpful. And then just lastly, is your hiring completed at this point in terms of the buying staff, IT, field personnel? And if not, will there be additional hires this year? Or will there be more next year?

Neill P. Davis

There are additional hires this year in all of those areas you've talked about or mentioned, and they're all generally reflected in the numbers that Mark has helped frame for you in terms of outlook. As it relates to next year, as we grow our online space and pursue that, there will be incremental hires, and then just natural growth for the business as a whole. And anything we have learned in places where we can build on the business more productively and effectively and if it requires incremental payroll, then it will come from there. But I think Mark, I guess, to step back a minute, we're getting very close to rounding out a lot of that infrastructure. I think the last biggest step, in my mind, outside of e-commerce, was what Theresa has done with her multi-unit organization. Because I believe that framework, and she believes as well, that that's what we need for our 900-boutique chain. Maybe they may be incremental pieces, but the architecture is where it needs to be.

Operator

And that concludes today's question-and-answer session. I would like to turn the conference back over to Mr. Neill Davis for any closing remarks.

Neill P. Davis

We appreciate everyone's continuing interest in Francesca. I think we have a great story. The one thing I do want to say is thanks to all the employees that may be listening on this call that do a great job for us, and they should know that we're very appreciative of it and look forward to their continued hard work in the months and years to come. Thank you, and we'll talk to you next quarter.

Operator

And that concludes today's teleconference. Thank you for your participation.

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